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SUPPLY AND

DEMAND

H.B.HENOEESOM

50N0MIC HANCffiOO&S

1 1 (■

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H,45

CORNELL

UNIVERSITY

LIBRARY

Gift in memory of

MARY STEPHENS SHERMAN, '13

from

JOHN H. SHERMAN, '11

DATE

DUE

HI! iliA^iinnnii

GAYLORD

PRINTED IN U.SA

CORNELL UNIVERSITY LIBRARY

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CAMBRIDGE ECONOMIC HANDBOOKS.— I

GENERAL EDITOR: J. M. EETNEB, M.A., C.B.

SUPPLY AND DEMAND

SUPPLY AND
DEMAND

KJ^

BY ■ {V"

HUBERT D. HENDERSON

(^1

>- l^^^

FELLOW OF CLARE} COLLEQB, CAMBBIDOE
LECTUBEB IN EOONOMIGS IN THE mnvBBBITT OF CAMBBIDOE

WITH AN INTRODUCTION BY

J. M. KEYNES

M.A., G.B.
FELLOW OF EUrG's COLLEGE, CAMBRIDGE

NEW YORK
HARCOURT, BRACE AND COMPANY

f74^///^

Printed in the V. 8. A.

INTRODUCTION

The Theory of Economics does not furnish a body
of settled conclusions immediately applicable to policy.
It is a method rather than a doctrine, an apparatus of
the mind, a technique of thinking, which helps its
possessor to draw correct conclusions. It is not difficult
in the sense in which mathematical and scientific
techniques are difficult; but the fact that its modes of
expression are much less precise than these, renders ,
decidedly difficult the task of conveying it correctly to
the minds of learners.

Before Adam Smith this apparatus of thought
scarcely existed. Between his time and this it has been
steadily enlarged and improved. Nor is there any
branch of knowledge in the formation of which English-
men can claim a more predominant part. It is not
complete yet, but important improvements in its
elements are becoming rare. The main task of the
professional economist now consists, either in obtaiaing
a wide knowledge of relevant facts and exercising skill
in the application of economic principles to them, or in
expounding the elements of his method ia a lucid,
accurate and illuminating way, so that, through his
instruction, the number of those who can think for
themselves may be iocreased.

This Series is directed towards the latter aim. It
is intended to convey to the ordinary reader and to the
uninitiated student some conception of the general

vi INTRODUCTION

principles of thought which economists now apply to
economic problems. The writers are not concerned to
make original contributions to knowledge, or even to
attempt a complete summary of all the principles of the
subject. They have been more anxious to avoid ob-
scure forms of expression than difficult ideas; and their
object has been to expoimd to intelligent readers,
previously unfamiliar with the subject, the most sig-
nificant elements of economic method. Most of the
omissions of matter often treated in textbooks are
intentional; for as a subject develops, it is important,
especially in books meant to be introductory, to discard
the marks of the chrysalid stage before thought had
wings.

Even on matters of principle there is not yet a
complete imanimity of opiaion amongst professors.
Generally speaking, the writers of these volumes be-
lieve themselves to be orthodox members of the Cam-
bridge School of Economics. At any rate, most of
their ideas about the subject, and even their prejudices,
are traceable to the contact they have enjoyed with the
writings and lectures of the two economists who have
chiefly influenced Cambridge thought for the past fifty
years, Dr. Marshall and Professor Pigou.

J. M. Keynes.

CONTENTS

CHAPTER I
THE ECONOMIC WORLD

PAGE

§ 1. Thboky and Fact 1

§ 2. The Division op Labor 3

§ 3. The Existence of Ordek 5

§ 4. Some Reflections upon Joint Products . . 7

§ 5. Some Reflections upon Capital . . .11

§ 6. The Fundamental Character of many Economic

Laws 17

CHAPTER II

THE GENERAL LAWS OF SUPPLY AND DEMAND

§ 1. Peeliminaey Statement of Three Laws . . 18
§ 2. Diagrams and their Uses . . .21
§3. Ambiguities of the Expressions, "Increase in

Demand," etc 24

§ 4. Reactions op Changes in Demand and Supply on

Price 27

§ 5. Some Paradoxical Reactions of Price Changes on

Supply 30

§ 6. The Disturbances of Monetary Changes . . 33

§ 7. The Trade Cycle 34

CHAPTER III

UTILITY AND THE MARGIN OF CONSUMPTION

§ 1. The Forces behind Supply and Demand . . 37
§ 2. The Law of Diminishing Utility .40

vii

viii

CONTENTS

page

§3.

The Relation Between Price and

Marginal

Utility ......

. 43

§4.

The Marginal Purchaser .

. 44

§5.

The Business Man as Purchaser

. 47

§6.

The Diminishing Utility op Money

. 49

CHAPTER IV
COST AND THE MARGIN OF PRODUCTION

52
55
57
59
60

( 1. An Illustration from Coai.

! 2. The Various Aspects of Marginal Cost

) 3. The Dangers of Ignoring the Margin

! 4. A Misinterpretation .....

! 5. Some Consequences of a Higher Price Level

j 6. General Relation Between Price, Utility and

Cost 65

CHAPTER V

JOINT DEMAND AND SUPPLY

! 1. Marginal Cost under Joint Supply . . .66

j 2. Marginal Utility under Joint Demand . 69

! 3. A Contrast Between Cotton and Cotton-seed, and

Wool and Mutton ...... 71

i 4. The Importance of being Unimportant . 74

! 5. Capital and Labor ...... 76

( 6. Conclusions as to Joint Supply and Joint Demand 79

( 7. Composite Supply and Composite Demand . . 79

( 8. Ultimate Real Costs . . . . .82

CHAPTER VI

LAND

i 1. The Special Characteristics op Land . . .83
! 2. The Scarcity Aspect ...... 84

CONTENTS

§ 3. The Difpeebntial Aspect

§ 4. The Margin op Transference

§ 5. The Necessity of Rent

§ 6. The Question op Real Costs

§ 7. Rent and Selling Price

§1
§2
§3
§4,
§5
§6
§7

CHAPTER VII
RISK-BEARING AND ENTERPRISE
Profits and Earnings of Management
The Payment fob Risk-bearing ,
Monte Carlo and Insurance
Risk under Large Scale Organization
The Entrepreneur ....
Risk-taking and Control
General Analysis op Profits

CHAPTER VIII
CAPITAL
§ 1. A Reference to Marx
§ 2. Waiting for Production
§ 3. Waiting for Consumption .
§ 4. Capital not a Stock op Consumable Goods
§ 5. The Essence of Waiting
§ 6. Individual and Social Saving
§ 7. The Necessity op Interest .
§ 8. The Supply op Capital
§ 9. Involuntary Saving ....
§ 10. Interest and Distribution .

CHAPTER IX
LABOR
§ 1. A Retrospect on Laissez-faire
§ 2. Ideas and Institutions

page

100

102

104
104
105
111
113
116
117

119
120
121
123
126
127
129
130
134
137

139
141

X CONTENTS

PAGE

§ 3. The General Wage-level . . . . • 143

§ 4. The Supply of Labob in General .... 145

§ 5. The Apportionment of Labor among Places . . 147

§ 6. The Apportionment of Labor among Social

Grades 149

§ 7. The Apportionment of Labor among Occupations 153

§ 8. Women's Wages ....... 157

CHAPTER X

THE REAL COSTS OF PRODUCTION

§ 1. Comparative Costs ...... 162

§ 2. The Allocation of Resources .... 166

§ 3. Utilitt and Wealth ...... 170

§ 4. Criteria op Policy 172

SUPPLY AND DEMAND

CHAPTER I

THE ECONOMIC WORLD

§ 1. Theory and Fact. The controversy between the
"Theorist" and the "Practical Man" is common to
all branches of hiiman affairs, but it is more than usually
prevalent, and perhaps more than usually acrid in the
economic sphere. It is always a rather foolish contro-
versy, and I have no intention of entering into it, but
its prevalence makes it desirable to emphasize a plati-
tude. Economic theory must be based upon actual
fact: indeed, it must be essentially an attempt, like all
theory, to describe the actual facts in proper sequence,
and in true perspective; and if it does not do this it is
an imposture. Moreover, the facts which economic
theory seeks to describe are primarily economic facts,
facts, that is to say, which emerge in, and are concerned
with, the ordinary business world; and it is, therefore,
mainly upon such facts that the theory must be based.
People sometimes speak as though they supposed the
economist to start from a few psychological assumptions
(e. g. that a man is actuated mainly by his own self-
interest) and to build up his theories upon such founda-
tions by a process of pure reasoning. When, therefore,
some advance in the study of psychology throws into

2 SUPPLY AND DEMAND

apparent disrepute such ancient maxims about human
nature, these people are disposed to conclude that the
old economic theory is exploded, since its psychological
premises have been shown to be untrue. Such an
attitude involves a complete misunderstanding not
merely of economics, but of the processes of human
thought. It is quite true that the various branches of
knowledge are interrelated very intimately, and that
an advance ia one will often suggest a development in
another. By all means let the economist and psychol-
ogist avoid a pedantic specialism and let each stray
into the other's province whenever he thinks fit. But
the fact remains that they are primarily concerned,
with different things: and that each is most to be
trusted when he is upon his own ground. When,
therefore, the economist indulges in a generalization
about psychology, even when he gives it as a reason for
an economic proposition, in nine cases out of ten the
economics will not depend upon the psychology; the
psychology will rather be an inference (and very
possibly a crude and hasty one) from the economic
facts of which he is tolerably sure.

But the purpose of economic theory is not merely to
describe the facts of the economic world; it is to de-
scribe them in their proper sequence and true per-
spective. It must begin with those facts which are
most general and which have the widest possible
significance. Those are not likely to be the facts
which our practical experience forces most insistently
upon our notice. For it is the particular and not the
general, the differences between things rather than their
resemblances, that concern us most in daily life. Nor

THE ECONOMIC WORLD 3

are we likely to find the universal facts which we
require in the sphere of public controversy. We must
rather look for them in the dark recesses of our con-
sciousness, where are stored those truths which are so
obvious that we hardly notice them, which are so indis-
putable that we seldom examine them, which seem so
trite that we are apt to miss their full significance.

§ 2. The Division of Labor. There is one such truth
in the economic sphere which it is essential to appreciate
vividly and fully, with the widest sweep of the imagina-
tion and the sharpest clarity of thought. Man lives by
cooperating with his fellow-men. In the modern
world, that cooperation is of a boimdless range and an
indescribable complexity. Yet it is essentially un-
designed and uncontrolled by man. The himiblest
inhabitant of the United States or Great Britain de-
pends for the satisfaction of his simplest needs upon
the activities of innumerable people, in every walk of
life and in every corner of the globe. The ordinary
commodities which appear upon his dinner table
represent the final product of the labors of a medley of
merchants, farmers, seamen, engineers, workers of
ahnost every craft. But there is no human authority
presiding over this great complex of labor, organizing
the various units, and directing them towards the
common ends which they subserve. Wheel upon
wheel, in a ceaseless succession of interdependent
processes, the business world revolves: but no one has
planned and no one guides the intricate mechanism
whose smooth working is so vital to us all. Man, in-
deed, can organize and has organized much. Within

4 SUPPLY AND DEMAND

a large factory the efforts of thousands of work-people,
each engaged on the repetition of a single small process,
are fitted together so as to form an ordered whole by
the conscious direction of the management. Some-
times factory is joined with factory, with farms, fish-
eries, mines, with transport and distributing agencies,
as one gigantic business unit, controlled by a common
will. These giant businesses are remarkable achieve-
ments of man's organizing gifts. The individuals who
control them wield an immense power, which so im-
presses the public imagination that we dub them
"kings," "supermen," "Napoleons of industry." But
how small a portion of man's economic life is dominated
by such men! Even as regards the affairs of their own
businesses, how narrow, after all, are the limits of their
influence! The prices at which they can buy their
materials and borrow their capital, the quantities of
their products which the public will consume, are
factors at once vital to their prosperity and outside
their own control.

A great business, like a nation, may cherish visions of
self-sufficiency, may stretch its tentacles forward to the
consumer and backwards to its supplies of raw mate-
rial; but each fresh extension of its activities serves only
to multiply its points of contact with the outside world.
When those points are reached, the largest business,
like the smallest, is out on the open sea of an economic
system immeasurably larger and more powerful than
itself. There it must meet — ^the better perhaps for its
inherent strength and accumulated knowledge — ^the
impact of rude forces, which it is powerless to control.
Beneath the blasts of a trade depression, or some other

THE ECONOMIC WORLD 5

tendency of world-wide scope, the authority of the
mightiest industrial magnate, and equally of any
Government, assumes the same essential insignificance
as the pride of a man humbled by contact with the
elemental powers of nature.

§ 3. The Existence of Order. The parallel can be
pursued further with advantage. Just as in the world
of natural phenomena, which for long seemed to man so
wayward and inexplicable, we have come gradually
to perceive an all-pervading uniformity and order; so
there is manifest in the economic world, imiformity,
order, of a similar if less majestic kind. Upon the
cooperation of his fellowmen, man depends for the very
means of life: yet he takes this cooperation for granted,
with a complacent confidence and often with a naive
unconsciousness, as he takes the rising of to-morrow's
sun. The reliability of this unorganized cooperation
has powerfully impressed the imagination of many
observers.

"On entering Paris which I had come to visit,"
exclaimed Bastiat some seventy years ago, "I said to
myself — Here are a million of human beings who would
all die in a short time if provisions of every kind ceased
to flow towards this great metropolis. Imagination is
baflled when it tries to appreciate the vast multiplicity
of commodities which must enter to-morrow through
the barriers in order to preserve the inhabitants from
falling a prey to the convulsions of famine, rebellion,
and pillage. And yet all sleep at this moment, and their
peaceful slumbers are not disturbed for a single instant
by the prospect of such a frightful catastrophe. On

6 SUPPLY AND DEMAND

the other hand, eighty departments have been laboring
to-day, without concert, without any mutual under-
standing, for the provisioning of Paris."

The theme may well excite wonder. But wonder
should always be watched with a wary eye; for he is
apt to bring in his train a hanger-on called worship,
who can do nothing but mischief here. It is a short step
from a passage like that quoted above to a glorification
of the existing system of society, to a defence of all
manner of indefensible things; and a cross-grained
attitude towards all projects of reform. It is a short
step; but it is one which it is quite unjustifiable to take.
For the evils of our economic system are too plain to be
ignored; too many people have harsh personal experi-
ence of the wastefulness of its production, the iajustice
of its distribution; of its sweating, its imemployment
and slimis. And when the attempt is made to plaster
over evils such as these with obsequious rhetoric about
the majesty of economic law, it is not surprising that the
spirit of many men should revolt and that they should
retort by denying the existence of order in the business
world, by declariag that the spectacle which they see is
one of discord, confusion and chaos. And then we are
engulfed in a controversy as stale, flat and unprofitable
as that between the "theorist" and the "practical
man."

The truth is that the language of praise and obloquy
is quite inappropriate. In the first place, it may be well
to note that the order of which I have spoken manifests
itself not merely in those economic phenomena which
are beneficial to man, but hardly less in those which
work to his hurt. Even in those alternations of good

THE ECONOMIC WORLD 7

and bad trade, which spell so much imemployment and
misery, there is discernible a rhythmic regularity like
that of the process of the seasons, or the ebb and flow
of the tide. This is not an elegance to be admired. Fur-
thermore, in so far as the order comprises adjustments
and tendencies which are beneficial (as, indeed, is
mainly true), there is no warrant for assuming that these
are either adequate to secure a prosperous community
or dependent upon the social arrangements which hap-
pen to exist. Let us, therefore, refrain from premature
polemics and examine in a spirit of detachment some
further aspects of the elaborate, but yet unorganized,
cooperation of which so much has been already said.

§ 4. Some Reflections upon Joint Products. A quite
inadequate idea of the complexity of this cooperation
is obtained by dwelling on the numbers of people who
participate in it, or the immense distances over which it
extends. The deficiency can be partially supplied by
referring to some of the more obvious of the many
subtle interconnections which exist between different
commodities and dififerent trades.

There are iimimaerable groups of commodities (which
it is customary to term "joint products") such that the
production of one commodity belonging to the group
necessarily imphes or very greatly facilitates the pro-
duction of the others. Wool and mutton; beef and
hides; cotton and cotton-seed are a few familiar illus-
trations. The important feature of these "joint prod-
ucts" is the fairly precise relation which must exist
between the quantities in which the different products
are supplied. If you plant a certain crop of cotton, it

8 SUPPLY AND DEMAND

will yield you so much cotton lint and so much cotton-
seed. You can, of course, if you choose, throw away
part of the seed, as indeed at one time planters used to
do; but unless you do this, you cannot vary the pro-
portions of the two things which you will have for sale.
Similarly, if you keep a flock of sheep, or a herd of cattle,
you will obtain wool and mutton in the one case, or beef
and hides in the other, in proportions, which indeed you
can vary withia certain limits by choosing a different
breed,^ but which you cannot radically transform.
When, however, we turn to the uses to which these
products are put, no similar relation is to be discovered.
Cotton lint is used chiefly for making articles of cloth-
ing; cotton-seed for crushing into oil, on the one hand,
and cake for cattle fodder on the other. There is no
apparent connection of any kind between the demands
for these different things, and still less is there any
obvious reason why these demands should bear to one
another the particular proportions which characterize
their respective suppUes. It is very much the same with
wool and mutton; with beef and hides; with all "joint
products." Why should we consume mutton on the
one hand and woolen clothing on the other, in a ratio
at all commensurate with that in which they are
yielded by the sheep?

What, then, might we expect to find if order was non-
existent ia the economic world? Surely that some
things such as wool would be produced in quantities
many times in excess of the demand for them, quite

' These possibilities of small variation are of very great impor-
tance as will be shown in Chapter V, but they do not affect the
present argument.

THE ECONOMIC WORLD 9

possibly five, ten, or twenty times in excess; while
conversely the supplies of others such as mutton might
fall far short of what was required. But in practice we
find nothing of the sort. Somehow it comes about
that an equilibrium is established between the demand
for and the supply of every commodity; and that this
applies to wool and mutton, to beef and hides, as surely
as to commodities which are produced quite independ-
ently. It is true that this equiKbrimn is a rough,
imperfect one; and it may happen that what is called a
"glut" of wool may co-exist for a short period with
what is called a scarcity of mutton. But qualifications
of this nature are in the strictest sense of the phrase, the
exceptions which prove the rule. For the departures
from equilibrium which gluts and scarcities represent
are always transient and are usually confined within
narrow limits. A strong prevailing trend towards an
adjustment of demand and supply is unmistakably
manifest amid all the vagaries of changing circumstance.
Let me carry the argument a step further for the
benefit of any reader who is restrained by a repugnance
too deep and instinctive to be readily overcome, from
admitting fairly to his mind that conception of order
which I am endeavoring to emphasize. He wiU in all
probability be one who, cherishing ideals of a better and
fairer system of society, looks forward to a time when an
organized cooperation will be substituted for what he
regards as the existing chaos. Let us suppose that his
visions were fulfilled as completely as he could desire;
and that an immense system of SociaKsm were in exist-
ence, embracing not one country only, but the whole
world. Suppose all the difliculties of human perversity

10 SUPPLY AND DEMAND

and administrative technique to have been surmounted
and a wise, disinterested executive to be in supreme
control of our business life. Let us suppose aU this, and
ask only tl^e question : How would this executive treat
the humdrum case of wool and mutton? How would
it decide the number of sheep it would maintain?

Shall we suppose that it is inspired by the ideal "to
each according to his need," and that it resolves accord-
ingly that the commodities which people require for a
decent standard of life shall be supphed to them as a
matter of course? How, then, would it proceed? It
might estimate the amount of woolen clothing which a
normal family requires, allowing for differences in
climate, and possibly indulging somewhat the caprices
of human taste. On this basis, a certain number of
sheep would be indicated. It might perform a similar
calculation for mutton, and again a certain number of
sheep would be indicated. But it would be an ex-
traordinary coincidence if the mmibers which resulted
from these independent calculations were nearly equal
to one another, or were even of the same order of mag-
nitude; and, if they differed widely, what number would
our world executive select? Would it decide to waste
an immense quantity of either wool or mutton; or
would it decide that it could not, after all, supply
the full human needs for one or other of the com-
modities?

Of course, if the executive were sensible it could solve
the problem satisfactorily enough. It could retain the
monetary system we know to-day and it could supply
the commodities to the consimiers, not as a matter of
right, but by selling them to them at a price. This price

THE ECONOMIC WORLD 11

it could then move upwards or downwards, raising, say,
the price of mutton and reducing that of wool, until it
found that the consumption of the two things was
adjusted in the required ratio. But if it acted in this
manner, what essentially would it be doing? It would
be seeking by deliberate contrivance to reproduce, in
respect of this particular problem, the very conditions
which occur to-day without aim or effort on the part of
anyone at all.

The moral of this illustration must not be misin-
terpreted. It does not show the folly of Socialism or the
superiority of Laissez-faire. What it does show is the
existence in the economic world of an order more
profound and more permanent than any of our social
schemes, and equally applicable to them all.

§ 5. Some Reflections upon Capital. Another aspect
of the great cooperation is of even greater significance.
It embraces not only a multitude of Hving men, but it
links the present together with the future and the past.
The goods and services which we enjoy to-day we owe
only in part to the labors of the week, the month, or
the year, only in part even to the efforts of our contem-
poraries. The men, long since dead and forgotten, who
built our railways, or simk our coal mines, or engaged
in any of a great variety of tasks, are stiU contributing
to the satisfaction of our daily wants. The expression
is not altogether fanciful; for, had it not been reasonable
to expect that those labors would be of use to us to-day,
many of them in all probabihty would never have been
undertaken. It was to meet our present wants, and
even our future wants, that many men toiled on monot-

12 SUPPLY AND DEMAND

onous tasks ten, twenty, thirty years ago. And yet,
of course, we should deceive ourselves if we supposed
that this was the motive of these men, that our welfare
was the centre of their heart's desire. We in our turn
dedicate to the future, and often to a distant future,
an immense portion of our energies. Let any reader
who doubts this, study the statistics of the occupations
of the people, and reflect on how long a period must
elapse before the labors of this trade or that can fulfil
their ultimate fimction. How long would the period be
in the case of a man making bricks, which wiU later be
employed in the erection of a factory, where machinery
will be made, to equip an electrical generating station
designed to supply, over a period of many years, Kght,
heat, and power to people living in a remote Continent?
A longer time, it may be hazarded, than he is accus-
tomed to look ahead.

Like the daily cooperation of living men, this coopera-
tion of past, present and future is essential to the
well-being of mankind, and yet it is undesigned and
unorganized. As private individuals, men do, indeed,
dehberately provide for their own future, and for that
of their kith and kin: as the directors of businesses,
they try to forecast the trend of demand. But such
conscious calculations and dehberate acts would avail
little if they stood alone. They are hardly more than
the necessary spokes in the great wheel which regulates
the relations of past, present and future. The hub of the
wheel is an elaborate system of borrowing and lending,
essentially similar to the buying and selling of com-
modities. The private individual in order to provide
for his family or for his old age "saves" and "invests."

THE ECONOMIC WORLD 13

But what exactly does this mean? It means that he
transfers so much purchasing power, which he might
have spent on his personal pleasm-es, to some one else
in return for the expectation of receiving, year by year
in the future, he and his heirs after him, a certain smaller
quantity of purchasing power. The other party to
the transaction will be, we may suppose, a business
man who enters into it because he sees the opportunity
of a promising industrial development, to imdertake
which he requires more purchasing power than he him-
self possesses. And, because this transaction is entered
into, a smaller number of us will shortly be engaged in
making motorcars, or gramaphones, and a larger niun-
ber of us in making factories and machinery, which will
later enhance the world's productive power.

Many transactions of the kind take place daUy in
modem communities, and their multipUcity gives rise
to a mass of phenomena with which we are all tolerably
famihar. We recognize a short-loan market, a stock
exchange, a niunber of "markets" where lenders and
borrowers are brought together by the aid of various
intermediaries, such as banks, bill brokers, and stock
jobbers, who correspond to dealers in commodities.
Between these different specialized markets, we are
aware of an interconnection so close and strong that we
speak more generally of a Capital Market, of which the
stock exchange, the short-loan market and so forth, are
the component parts. Now, "market" is a word which
was originally used to denote a place where tangible
commodities were bought and sold; and the more
closely we examine the phenomena of the Capital
Market, the more closely do we perceive the profound

14 SUPPLY AND DEMAND

resemblance between the mechanism of borrowing and
lending, and that of buying and selling. Corresponding
to the price of a commodity is the rate of interest (ini
the short-loan market we actually call the rate of dis^
count "the price of money," and speak of money being
cheap or dear); and between the rate of interest, the
demand for and the supply of capital there exist rela-
tions precisely similar to those between price, demand;
and supply in commodity markets. Above all there is
the same strong prevailing trend towards an adjust-
ment of demand and supply.

This fimdamental resemblance between two such
apparently incommensurable things as the buying of
material commodities and the borrowing of capital is
highly significant; it is another instance of that order
in the economic world, of which the reader may now
be growing weary. But so difficult is it to see clearly
and fully something which one sees, as it were, every
day of one's life, that a few more moments of reflection
on the special case of capital will be time well spent.
Let us revert then to our fantasy of a world socialist
commonwealth; and humbly submit another poser
to its supreme executive. The question this time will be
whether some great constructional work, such, let us
say, as the recently mooted Severn barrage scheme,
should or should not be undertaken. Let us suppose
that the costs and future benefits of the undertaking
can be estimated accurately; and that the problem
reduces itself 'to one of expending now a simi, let us say,
of $100,000,000, with the prospects of obtaining in the
future an income of power, or whatever it may be, worth
$5,000,000 per annum. I have assimied for the sake of

THE ECONOMIC WORLD 15

simplicity that we shall still be reckoning in terms of
money, though possibly the executive may have
substituted Marxian labor vmits; but it is quite im-
material to the present argument what the measuring
rod may be. The point to be observed is, that it is
impossible to tackle the problem at all without the
conception of a rate of interest. For suppose that you
tried to do without it, and said, "We shall take a long
view. The interests of the future are no less our concern
than those of the present; we shall not discriminate
between them. We shall regard as an enterprise worthy
to be undertaken whatever promises to yield in the
course of time a return larger than the outlay." Where
will this lead you? The particular proposal set out
above would clearly pass the test; for in twenty years
the resultant benefits would have added up to a figure
equivalent to the initial cost. But equally clearly,
the cost might have been more than $100,000,000; it
might have been $250,000,000, $500,000,000, whatever
figure you care to take, and if you extend the period
similarly to fifty or one hundred years, sooner or later
the gains would top the cost. Now there is no limit to
the enterprises which would pay their way on this
basis; and it would be quite impossible to undertake
them all. For they would swallow up all and more than
all your labor and your materials, and would leave
you with no resources with which to meet the recurrent
daily wants of men. Clearly, then, in some way or
other, you must pick and choose, you must reject some
enterprises as insuffidenfly worth while. But how
would you proceed to choose? Without a clear prin-
ciple, a simple criterion to guide you, you would be

16 SUPPLY AND DEMAND j

plunged in utter chaos. You could not say, "Let all
proposals involving capital expenditure be submitted
to a central committee, who shall compare them wiph
one another in a sort of competitive examination anfl,
after deciding the number of applications they can pass
on the basis of the volume of resources which they can
devote to the future, award the places to those which
head the list." Such a prospect is a nightmare of
officialism and delay. You would be driven to for-
mulate a simple, intelligible rule or measure, and leave
that rule to be applied by the xmfettered judgment of
innimierable men to individual problems, as and when
they arose. And for such a rule or measure, you could
not do better than a rate of interest; you would have to
lay it down that only those projects should be ap-
proved which promised a return of 6 per cent, or what-
ever it might be. Even in deciding what it should be,
the limits of your choice would be narrowly confined.
If, for instance, you fixed on 1 or 2 per cent, you would
probably discover that you had not achieved your
object, that the undertakings for distant retm-ns which
passed this test, still consumed far more resources than
you could spare. You would be compelled then to raise
the rate until it had cut these enterprises down within
manageable limits. But, once more, what essentially
would you be doing? You would be using the instru-
ment of the rate of interest to adjust the demand for
and supply of capital, though indeed the interest might
not be paid away as now to private individuals. You
would be reproducing by the method of deliberate trial
and error, the adjustments which occvu- automatically
as things are, in the actual world. Once again the most

THE ECONOMIC WORLD 17

perfectly contrived Utopia would be compelled to pay-
to the unorganized cooperation of our epoch the sin-
cerest flattery of imitation.

§ 6. The Fundamental Character of many Economic
Laws. But again perhaps a word of warning may be
desirable. There is much controversy iti these days
about somethiag called "Capitalism" or "The capitalist
system." When these words are used with any pre-
cision, they usually refer to the arrangement so prev-
alent at present, whereby the ownership and sole
ultimate control of a biisiness rests with those who hold
its stocks and shares.. There is much to be said upon
the merits and demerits of this system; something will
perhaps be said upon the matter in the fifth volume of
this series; but I shall not discuss it here. Nothing
that I have said so far has any real bearing on it what-
soever; to suppose that it has, is indeed to miss the
whole point of this chapter.

The order, which I have sought to reveal, pervad-
ing and moving the most diverse phenomena of the
economic world, would be a far less noteworthy and
impressive thing were it merely the peculiar product of
capitalism. Merchant adventurers, companies, and
trusts; Guilds, Governments and Soviets may come and
go. But imder them all, and, if need be, in spite of them
all, the profound adjustments of supply and demand will
work themselves out and work themselves out again
for so long as the lot of man is darkened by the curse
of Adam.

CHAPTER II

THE GENERAL LAWS OF SUPPLY AND
DEMAND

§ 1. Preliminary Statement of Three Laws. The recogni-
tion of order in any branch of natural phenomena is
but the prelude to the formulation of a set of laws,
the simpler as the order is more tiniversal, which de-
scribe, and as we say, explain it. Thus the perception
of the even, elliptical courses of the heavenly bodies led
to the statement of the law of gravitation and the laws
of motion.

In economics, similar laws have long since been
enunciated, and have proved themselves such valuable
instruments for the imderstanding of the daily problems
of the workaday world, that they have been woven
into the texture of our ordinary speech and thought.
I have already touched upon them in the preceding
chapter. But it is now desirable to set them out in
order, in the most concise and formal manner possible.

I. When, at the price ruliag, demand exceeds
supply, the price tends to rise. Conversely
when supply exceeds demand the price tends
to fall.

II. A rise in price tends, sooner or later, to
decrease demand and to increase supply.
Conversely a fall in price tends, sooner or

GENERAL LAWS 19

later, to increase demand and to decrease
supply.

m. Price tends to the level at which demand is
equal to supply.

These three laws are the cornerstone of economic
theory. They are the framework into which all analysis
of special, detailed problems must be fitted. Their
scope is very wide. I have purposely refrained from
introducing into my statement of them any reference
to commodities; for they extend far beyond com-
modities. Subject to an important qualification, they
apply to capital, the price paid for the use of capital
being what we call the rate of interest. They apply
hardly less to "services," to the remuneration of labor
of every kind and grade. People sometimes protest
warmly against the idea of treating labor "like a com-
modity." If this indignation expresses no more than a
beUef that in matters concerning conditions of work,
and relations between employ^ is and the management,
the sensibilities of human nature should be taken into
due accoimt, it is based on elementary decency and
commonsense. But if, as sometimes appears, it is
directed against the fact that the remuneration of
labor is controlled by the laws of supply and demand,
it is a mere baying at the moon, with singularly little
provocation. For these laws are in no way peculiar to
commodities, and it is no one's fault that they include
commodities too within their scope.

But let us go back to the laws themselves, and probe
them and dissect them, and turn them this way and
that, so that we may perceive their full content, and

20 SUPPLY AND DEMAND

grasp it firmly in our minds. The third law implies a
prevailing tendency for demand to be equal to supply.
This tendency, as was suggested in Chapter I, can be
verified by anyone from his experience and observation
(provided he is a reasonable person, and not the tire-
some kind who would dispute the law of gravitation
because he sees that a feather falls to the ground more
slowly than a stone). But it can also be deduced as a
corollary from the two preceding laws; and to regard it
in this way wiU help us to appreciate its significance.
Start, for instance, by supposing that demand is in
excess of supply. Then the price will tend to rise. After
the price has risen, the supply will become larger, while
the demand will fall away. The excess of demand
with which we started will thus clearly be diminished.
But if there remains any portion of this excess, the
same reactions will continue; the price will rise further,
and for the same reason; demand will be further
checked and supply further stimulated. In other words,
these forces must persist until the entire excess of
demand over supply is eliminated. If we start by
supposing supply to exceed demand, the converse chain
of sequences will operate. Now these very simple steps
of reasoning illuminate the nature of the normal equi-
libriiun of demand and supply. They reveal that the
equilibrium is established and maintained by the
agency of changes in price, and they enable us to lay it
down as perhaps the most important thing that can be
said about the price of anything that it will tend to be
such as will equate demand and supply. But that is not
all that they reveal. They reveal also the extreme
dependence of both demand and supply upon price.

GENERAL LAWS 21

Now this is a fact which it is most important to realize
vividly. It is apt to be obscured by customary modes
of speech. In ordinary times the prices of most com-
modities and services do not change by very much,
unless indeed over a long period of years; the amoimts
demanded and supplied may therefore seem to main-
tain a fairly constant level; and we may be tempted to
speak of Great Britain producing so many million tons
of coal, or America consuming so many millions of
motor-cars per annum, almost as though these quan-
tities were independent of price considerations. But
we should never forget that there is no service or com-
modity produced by man, however essential it may
seem, the demand for or the supply of which might not
be reduced to nothing, if the price were sufficiently
raised on the one hand, or lowered on the other. How
easy it is sometimes to forget this simple truth may be
seen from the mistake so commonly made of supposing,
because the peoples of Central Etu-ope were left, on the
cessation of the war, starving and destitute of the
means of life and the materials of work, that they must
necessarily become heavy purchasers of imported
goods; without pausing to consider whether the prices
were such as they could afford to pay.

§ 2. Diagrams and their Uses. It will help to prevent
mistakes like this and more generally to make sharp and
clear the fundamental relations which exist between
demand, supply and price, if we exhibit them pictorially
in the form of a diagram. Such diagrams are of great
service in many parts of economic theory, not because
they can prove anything which could not be proved

SUPPLY AND DEMAND

otherwise, but because, being really a simpler medium
of expression than words, they enable the mind to
grasp more readily and to retain more vividly the essen-
tial facts of complex relations.

In Fig. 1 the curve DD' represents the conditions of
demand. It is supposed to be drawn in such a way that
if any point, Q, be taken on the curve, and the perpen-

FlG. 1.

dicular QN be drawn to meet the base line, or axis OX,
then ON will represent the amount that will be de-
manded at a price represented by QN (or 01). In other
words, distancgp measured along OY represent prices, .
and distance/measured along OX represent quantities
of the commodity, or service, or whatever it may be.
Clearly, then, the demand curve, DD', must slope
downwards from left to right, since the lower the
price asked, the greater will be the amount demanded.
Similarly the curve SS' represents the conditions of

GENERAL LAWS 23

supply. It is supposed to be so drawn that if any
point q be taken upon it, and the perpendicular gN
be drawn to meet OX, then ON will represent the
amount that will be supplied at a price represented by
gN (or OK). Equally clearly this supply curve must
slope upwards from left to right, since the higher the
price obtainable, the greater will be the quantity
offered. Take the point P where the two curves meet,
and draw the perpendicular PM to meet OX. Then
the third law enunciated at the beginning of this
chapter corresponds to the statement that PM or Ow
will represent the price at which the commodity or
service will be exchanged.

It can readily be seen that no other price could be
maintained. For suppose the price to be less than Om,
suppose it to be OA;, then, at this price, ON (or kq) will
be the amount suppUed, and hr the amount demanded.
The demand will thus exceed the supply, and the
price will tend to rise, i. e. to move upwards towards
Om. Similarly if we suppose the price to be 01, which
is larger than Om, the supply (ZR) will exceed the
demand (ZQ) and the price will fall downwards towards
Om. Thus, again, we have deduced Law III from
Laws I and II with the form and precision of a
proposition in Euclid. Now, when once the eye has
become familiar with this diagram, it ought to be
impossible for the mind to lose even momentarily its
grip on the fact that demand and supply are both
dependent upon price. For these curves do not repre-
sent any particular amounts; they represent a series of
reUxticms between amount and price; if the price is
QN the amount demanded is ON, and so forth. The

24 SUPPLY AND DEMAND

terms demand and supply in the sense, in which I
have been using them, of the respective amounts de-
manded and supplied are, indeed, strictly meaning-
less without reference to some particular price. The
reference may sometimes be implicit; but, whenever
there is a chance of ambiguity, it should be explicitly
made.

§ 3. Ambiguities of the Expressions, "Increase in De-
mand," etc. It is the more important to be precise
upon this point, in that there is a further possible
confusion which we have now to consider. Demand
and supply, as we have seen, are dependent upon
price; but equally clearly they are dependent upon
other things as well. Demand depends upon the needs,
tastes and habits of the people, as well as upon the
length of their purse; supply depends upon such things
as the cost of production in the case of commodities.
None of these things are constant factors, all of them
are liable to change, and it may well happen that we
shall want to consider in some concrete problem the
probable consequences of such a change. Now the
most usual and natural way of describing such changes
in the medium of words is to use the expression "in- '
crease" or "decrease in demand," and "increase"
or "decrease in supply," the same expressions, which
we employed before to describe the consequences of a
change ia. price. This identity of language conceals
a fimdamental distinction between the phenomena
described; and to make this distinction plain we cannot
do better than revert to our diagrammatic presentation
of the laws.

GENERAL LAWS

In Fig. 2 we start as before with our demand curve,
and supply curve, cutting one another at the point P.
We then suppose that some alteration takes place in
the conditions of demand; there has been a growth
in the general taste for the commodity or service, and
the demand, as we say, has increased accordii^ly.

M'M m
Fig. 2.

How is this fact to be represented in the diagram?
Plainly not by taking another point on the curve, DD',
at a further distance from OY. For this would merely
indicate the larger amount that would be taken, if the
conditions of demand had remaiued imaltered but the
sellers had reduced their prices. The correct way of
representing the change we have supposed is to con-
struct a new demand curve (in the figure, the dotted

26 SUPPLY AND DEMAND

curve M'), lying at every point above the old demand
curve. For this indicates that larger quantities will
be purchased at the old prices, which is exactly what
we want to represent. Similiarly if we wish to represent
a change in the conditions of supply, such as might
result, in the case of a commodity, from a tax imposed
on its production, we must draw a new supply curve,
ss', which in the case supposed, must lie everywhere
above the old supply curve. On the other hand, the
decrease or increase in demand or supply, resulting
from a change in price, is represented simply by a
shifting of the equilibrium from one point to another on
the same curve. The striking pictorial contrast be-
tween a movement from one curve to another, and a
movement along the same curve should help to make
vivid to our minds the fundamental distinction between
a change in the conditions of demand, arising from new
tastes, enhanced purchasing power, etc.; and a mere
change in the amount purchased resulting from an
alteration in the price which the sellers ask. Words,
as this necessarily cimibrous sentence shows, are a
clumsy instrument for the expression of abstract
relations; it is not very easy to see which words in a
sentence are the significant, commanding ones, and
which are performing, as it were, ordinary routine
duties. A diagram is not exposed to similar ambigui-
ties of emphasis.

The particular distinction, to which attention has
been called, is important. The reader who has grasped
it clearly will be able to perceive man;^ instances of the
confusion arising out of its neglect in the ordinary
discussions of economic questions which take place

GENERAL LAWS 27

in the press and on the platform. It is not uncommon,
for instance, for an argument to run something like
this: "The effect of a tax on this comnaodity might
seem at first sight to be an advance in price. But an
advance in price will diminish the demand; and a
reduced demand will send the price down again. It
is not certain, therefore, after all, that the tax will
really raise the price." A glance at the diagram will
keep us out of such a bog of sophistry and muddle.
For if we suppose the amount of the tax per unit of the
commodity to be represented by Ss, the curve ss'
(drawn, as it is, roughly parallel to SS') will represent
the new conditions of supply after the tax has been
imposed. The new position of equilibrium will be
given by the point P', where ss' cuts DD', the demand
curve. Now P' lies to the left of P the old point of
equilibrium; hence, since DD' must slope downwards
from left to right, it is clear that, if, as it is fair here to
assume, the conditions of demand have remained unal-
tered, the new price P'M', must be greater than the old.

§4. Reactions of Changes in Demand and Supply on
Price. Having now made clear the meaning that must
be attached to the terms, let us consider the question
which naturally arises, whether we can lay down any
general propositions or laws as to the effect upon
price, of an increase or decrease in demand or supply.
Another glance at the diagram suggests that we can.
An increase in demand is represented in Fig. 2 by a
movement from DD' to dd', which cuts the supply
curve, SS', at p, to the right of P. Since the supply
curve (drawn, as it is best to draw it, to represent the

28 SUPPLY AND DEMAND

amount which will be supplied in response to a given
price) must always slope upwards from left to right,
the new price, pm, must be greater than the old, PM.
Conversely a decrease in demand is represented by a
movement from dd' to DD', and the new price is
seen to be less than the old. We have already seen
that a decrease in supply, which is represented by a
movement from SS' to ss' results in a higher price;
and it is the obvious converse that an increase in
supply will have the opposite effect. It would seem
then that we might lay down quite generally that an
increase in demand or a decrease in supply wiU raise the
price while a decrease in demand or an increase in
supply will lower it.

But here it is necessary to be cautious. All con-
clusions as to the effects of causes are necessarily based,
implicitly, if not explicitly, upon the assumption
"other things being equal.' ' This method of reasoning,
which some people appear to find so irritating in the
economic sphere, and as they say so "theoretical"
and "uni-eal," is one which they adopt readily enough
in every other department of life. No one, for instance,
objects to the statement that the sun, when it comes
out, makes a room warmer, although it may very
well happen, if a fire is dying at the same time, that
the room grows colder in point of fact. For in our
general statement we assimie implicitly that "other
things" such as fires, are unchanged. But assumptions
of this kind are legitimate only when there is no reason
to suppose that the cause, the effects of which' are
being studied, will itself produce a change in the "other
things." If (as I have often been told; I really do not

GENEKAL LAWS 29

know if it is true) the rays of the sun help to put a
fire out, the statement made above would be the better
for some qualification.

Now we can only say that an increase in demand
raises price if we assume the conditions of supply (as
represented by the supply curve) to remain unchanged.
But in practice, an increase in demand may cause a
change in the conditions of supply. An increase, for
instance, in the demand for a commodity may give rise
to a revolution in the methods of production, to the
introduction of labor-saving machinery and so forth,
which will eventually result in the commodity being
produced more cheaply. It will certainly take a con-
siderable time before reactions of this kind can exert
an appreciable influence; and we can, therefore, feel
reasonably sure that over a short period an increase in
demand will raise the price. But we cannot be sure
what the ultimate effect will be. A similar alteration in
the condition of demand is less likely to result from an
increase or decrease in supply; but it may conceivably
occur. We must, therefore, be careful to qualify any
general propositions which we lay down in this connec-
tion, by explicit reference to a short period of time.
We can add the followii^ to our body of laws: —

IV. An increase in demand, or a decrease in supply
will tend to raise the price for a short period at
least. Conversely a decrease in demand, or an
increase in supply will tend to lower the price
for a short period at least.

This law, like the others, applies to commodities,
services, capital, to anything which can be said, liter-

30 SUPPLY AND DEMAND ^

ally, or by analogy, to have a price. "A short period"
is, however, a vague expression and, since precision is
the hallmark of an important law, we must accord to
this one a status inferior to that which the preceding
three can rightly claim.

§ 5. Some paradoxical reactions of price changes on
supply. Let us turn, though, once more to these
earlier laws, and with a heightened critical sense let us
submit them to the test of the whole gamut of our
experience, and see if in any of them we can find the
smallest flaw. The first of them will pass through
the ordeal — let each reader prove it for himself —
unscathed. The second will emerge with a few hairs,
as it were, singed. It tells us, for instance, that a rise
in price will tend to augment the supply. Now there
are some things the supply of which cannot possibly
be augmented; these are the capital resources of nature,
of which land is the most important for our present
purpose. Land is bought and sold, it commands a
price. In a certain sense, it may be said to be possible
to increase the supply of land, in response to a rise in
price, by drainage and reclamation schemes; and it
will certainly happen that a rise in the price which
land can command for any particular purpose will
increase the amount which is devoted to that purpose.
But, speaking broadly, the supply of land available
for purposes of every kind is a fixed unvarying factor, '
with an inertia which the cajolery of price-changes is
powerless to disturb. This is a most important fact,
and it gives rise to some peculiar features of the price
and rent of landj which we shall have to consider later

GENERAL LAWS 31

as a separate problem. It constitutes a limiting case
rather than an exception to the general law. But we
have not yet done with the reactions of price upon
supply. In the case of capital, the nature of those re-
actions has been much discussed as a highly controver-
sial question. That a rise in the rate of interest will
cause some people to save more than before, is gener-
ally admitted; but it is pointed out that the effect upon
others may be the exact opposite, because it means that
they do not need to save so much to acquire the same
future annual income. It is unwise to say dogmatically
that the former tendency outweighs the latter; though
upon the whole it seems highly probable that it does.
We cannot, therefore, in this case feel confident that a
change in price will react upon supply in the maimer
which our law indicates. Similarly it is possible to
argue that a rise in the general level of real wages may
reduce the supply of labor, even, or some might say
particularly, if the term is used to denote not the
number of workpeople, but the quantity of work done.
For there may be a tendency for workpeople, when
more comfortably off, to work less regularly or less
hard. Here again we cannot be sure. In none of
these cases, however, including that of land, is there
any reason to doubt that a rise in price will diminish
demand, or conversely that a fall will increase it. Since,
therefore, in the reasoning by which we deduced the
third law, the conclusion will hold good, even if the
effects of price-changes on supply are of the above
paradoxical kind, provided that they do not con-
tinually outweigh the effects upon demand, there is no
reason to cast doubt on the solidity of Law III, which,

32 SUPPLY AND DEMAKD

indeed, as we suggested before, commends itself directly
to experience. But Law II seems now, perhaps, some-
what the worse for wear.

The damage, however, is not considerable. For in
each case the uncertainty arises only when we are
dealing with one of the factors of production, land,
labor or capital, regarded as a whole. If we are dealii^
with the capital available for a particular industry, a
rise in the rate of profit in that industry will certainly
increase the supply of capital available there; for it will
tend to attract savings that might otherwise have been
employed elsewhere. We can even be fairly sure that
an increase in the general rate of interest prevailing in
any particular country will increase the total supply
of capital available for the businesses of that country,
since capital has in modem times acquired a consideiv
able migratory power. In the case of labor, we cannot
go so far as this; but here, too, there is no doubt that an
increase in the remuneration offered in any particular
occupation will attract an increased labor supply
(always supposing, of course, that "other things are
equal"). No similar difl&culty arises for land, labor
or capital, as regards the effect of price-changes on
demand; while for ordinary commodities there is no
such difficulty on the side either of demand or of
supply. Hence the only qualification which the
strictest accuracy would require us in this connec-
tion to attach to our statement of Law II is the
postscript: —

"Except that, in the case of land, the aggregate supply is
imalterable; while in the case of capital or labor we cannot be
sure how price-changes will affect the aggregate supply."

GENERAL LAWS 33

Much significance attaches to these exceptions, as
later will appear.

§ 6. The Disturbances of Monetary Changes. But let
us still keep a critical eye on Law II, and submit it
to another flashlight from our practical experience.
The recent world war made us all acutely aware of a
remarkable rise in the price of almost everything,
which yet did not seem to diminish appreciably the
demand. The explanation of this paradox is not
difficult to find. There was an immense increase in the
volume of nominal purchasing power, due to a complex
set of causes, of which "currency inflation" may be
taken as the symbol. Now perhaps we are entitled to
assume the absence of such currency changes as part of
the "other things being equal" which is always under-
stood as implied. But it is rash to take this particular
assumption for granted, more especially in these days.
Already people are too apt to speak as though the
trade depression (which as these pages are written
holds us in its grip) cannot pass away until pre-war
prices are restored, ignoring altogether the great and
probably permanent increase in nominal purchasing
power which the war has left behind it. It would be
safer, therefore, to add explicitly to Law II the reserva- ■
tion, "Assuming that there is no change in the general
volume of purchasing power."

Monetary and allied questions will form the subject
of the second volume of this series. It must not be
supposed that our general laws have no bearing on
them. On the contrary, Law I, which all this time has
remained serene and undisturbed by the occasional dis-

34 SUPPLY AND DEMAND

comfitures of Law II, is the gateway through which all
questions of currency, banking and the foreign ex-
changes should be approached. It is well to note, as an
inexorable corollary of Law I, that prices can rise only
if demand exceeds supply, and fall only if supply ex-
ceeds demand; and hence that it is only through the
agency of changes in the demand for and supply of
commodities and services that an inflation or deflation
of the currency can influence the price level. Further,
since a condition of things in which supply generally
exceeds demand spells what we know and fear as a trade
depression, it may be well to note at once that falling
prices and unemployment are inseparable bedfellows.
For we are far too apt to shut our eyes to these un-
pleasant truths. But we cannot pursue them further
here; and in the remainder of this volume we shall
not be concerned (except, perhaps, incidentally) with
questions affecting the general level of prices or of pur-
chasing power; but rather with the relation which the
price of one commodity bears to that of another, with
the rate of interest (which being a rate per cent is not
essentially dependent on the price level), with "real"
wages (as distinct from money wages) and the like.

§ 7. The Trade Cycle. But our reference to trade
depressions suggests a final comment on Law II. One
small qualification was embodied in our original state-
ment of it, namely the words "sooner or later." A rise
in price may not check the demand immediately (even
if the printing presses are standing idle in the Treas-
uries); it may actually stimulate it for a time. For
people may fear that the price will rise further still, and

GENERAL LAWS 35

hasten to buy what they must buy before very long.
Sellers may share the same opinion, and be reluctant on
their side to part. When prices are fallii^ the roles are
reversed, and we are likely to see the sellers tumbling
over one another in a frantic eagerness to sell, the
buyers wary and aloof. Sooner or later, indeed, these
tendencies must dissolve and disappear; but they may
persist for a longer period than might seem probable
at first. For the raw material of one trade is, as we say,
the finished product of another. The demand for one
thing gives rise to a demand for other things, for the
labor with which to make them, and so on in an ex-
panding circle. A sympathy, subtle and intense,
unites the business world, and a wave of depression or
animation arising in any quarter may spread itself far
and wide, heightened by the <5usts of human hope and
fear, and continue long before its influence is spent.

Here we are upon the threshold of one of the most
striking and formidable of economic facts, the regular
alternation of periods of good and bad trade, each very
widespread, if not world-wide, in its range, each com-
prising certain regular phases of acceleration and decay,
and each infallibly yielding sooner or later to the other.
The details of these phenomena are highly complex,
some of them obscure; an immense literature has
already been devoted to the subject, yet its systematic
study is hardly more than begun. The account given
in the preceding paragraph is incomplete and meagre.
It is inserted here in the hope that it will impress the
reader with a sense both of the fact of these alternations
and of the deeply rooted nature of the causes from which
they spring. They take a heavy toll of human happi-

36 SUPPLY AND DEMAND

ness and wealth; and there is no object that more
urgently calls for concerted human effort than that of
mitigating them, and of alleviating the misery which
they bring in. their train. Still better, of eradicating
them if that is possible; but let none suppose that it can
be lightly done. Meanwhile, let us always remember
that they form the atmosphere and medium in which
the enduring tendencies of the business world must
work themselves out. It is often convenient to speak of
"normal conditions" in this trade or that; but hardly
ever can it be truly said of a particular moment that
conditions are normal. The nonnal is rather a mean
level about which oscillations to and fro, round and
about, are constantly taking place, but which itself is
reached only by accident, if at all. Whenever we say
that some new factor should in the long run lower
the price of this or that conmiodity or service, the
pictiu'e which these words should convey to our mind
is one of the price rising less on times of boom, and
falling more in times of depression than is the case
with other things. And if ever our faith in some
honored economic law is shaken by the apparent ease
with which, perhaps, in times of active trade, sellers are
able to advance their prices to whatever figure (so it
ahnost seems) they choose to name, let us rally our
sense of economic rhythm, and reserve our judgment
until the trade cycle has run its course.

CHAPTER III

UTILITY AND THE MARGIN OF
CONSUMPTION

§ 1. The Forces behind Supply and Demand. The
laws enunciated in the preceding chapter constitute
the framework and skeleton of all economic analysis;
but they do not carry us very far. It is only through
the agency of these laws that any influence can affect
the price of anything: but what influences may so
affect it is a question which we have still to consider.

Let us begin with ordinary commodities and ask our-
selves, in the light of experience and common sense,
upon what factors their price seems mainly to depend?
Two factors spring to mind at once; their cost of pro-
duction and theii* usefulness. As regards the former, the
case seems clear enough. We may indeed sometimes
grumble that the price of this or that commodity is
unconscionably high in comparison with its cost; but
this only goes to show that we conceive a relation be-
tween price and cost as the normal, governing rule. If
one commodity cost only a half as much to produce as
another, we should think that something had gone very
wrong indeed, if the former commodity were sold for
the higher price. But, when we turn to the usefulness
of commodities, the case is not so clear. Usefulness has
some coimection with price, so much is certain; for an
entirely useless thing, fit only for the dust-bin (and

38 SUPPLY AND DEMAND

known to be such, it may be well to add) will fetch no
price at all, however costly it may be to produce. But
it is not easy to express the connection in quantitative
terms. It seems reasonable enough to say that the
prices of commodities are roughly proportionate to
their costs of production. But directly we contemplate
saying a similar thing of their usefulness, we are pulled
up short. As we look round the world, and enumerate
the commodities which by common consent are the
most useful, salt, water, bread, and so forth, the strik-
ing paradox presents itself that these are among the
cheapest of all commodities; far cheaper than cham-
pagne, motor-cars or ball-dresses, which we could very
well get on without. As things are, of course, a ball-
dress, or a motor-car costs more to produce than a loaf
of bread or a packet of salt; and the common-sense
explanation of the paradox seems, therefore, to be that
the cost of production is a more weighty influence
than the usefulness, or utility, as we will henceforth call
it (so as to include the satisfaction we derive from not
strictly useful things). We are thus tempted to con-
clude that, provided a commodity possesses some utility,
its price will be determined by the cost of production,
the degree of utility being unimportant. This was ex-
actly how the position was summed up for many years
in systematic treatises upon Political Economy; and
it was not until fully half a century after the Wealth
of Nations that a discovery was made which threw a
fresh light on the whole matter.

First of all, let it be clearly observed how very
unsatisfactory is the above account. In Chapter II
where we were treading surely, with a sense of solid ,

UTILITY 39

ground beneath us, we drew no such invidious dis-
tinction between supply and demand. They seemed
then to possess an equal status. But cost of production
is the chief factor which, in the case of commodities,
ultimately determines the conditions of supply. Util-
ity, similarly, is the chief factor which ultimately de-
termines the conditions of demand. Must not then the
symmetrical relations between demand and supply be
reflected in a corresponding symmetry between the
utiUty and the costs which underlie them? Demand
springs obviously from utility; the only motive for
bujdng anything is that it will serve some real or fancied
use. Can we then accord to demand so dignified and
to utility so subordinate a place? There is here an
inconsistency which we must somehow reconcile. It
will not serve as a solution to distingmsh between
different periods of time, and to say, as economists used
to say not very long ago, that price is governed over a
short period by demand and supply, but in the long run
by the cost of production. This still leaves our sense of
symmetry unsatisfied. Moreover, the conception of
cost of production, when we consider it as ruling over
a long period, frequently seems to lose any precision,
as an independent factor, which it may otherwise
possess. Motor-cars, we have agreed, are more costly
to produce than loaves of bread; but, as we know well,
the cost of producing motor-cars varies enormously,
accordingly as they are produced on a small or a large
scale. By the methods of mass production they can be
turned out at a relatively low cost per car. But this
requires that they should be purchased in large niunbers
and this in turn throws us back to the demand for

40 SUPPLY AND DEMAND

motor-cars, and plainly enough, to people's judgmenf^
as to their utility. In some cases, the opposite phe-
nomenon occurs. In the case of British coal, for in-
stance, the average cost of production would be much
lower than it is if the output were reduced to a fraction
of its present volume, and if only the richer seams of the
more fertile mines were worked. Once again, therefore
it is difficult to measure the cost of production until we
know the magnitude of the demand, which in a manner,
which we have still to elucidate, clearly depends upon
the utility.

If we take the problem of joint products, the con-
ception of cost of production fails us still more con-
spicuously. For what is the cost of producing wool,
or the cost of producing mutton? We can speak of
the cost of rearing sheep: but it is hardly , possible
to allot this cost, except quite arbitrarily, between
the two products. How, then, can we explain the
separate prices of these things by reference to cost
alone? Instances of joint production are becoming so
common in the modem world, or at least, with the
growing attention to the utilization of by-products, are
assuming so much more heightened a significance, that
an explanation of price, which does not apply to them,
is a very feeble one indeed.

§2. The Law of Diminishing Utility. Let us turn
back, then, to the factor of utility, and see if we cannot
put on a more satisfactory basis the relation between
utility and price. The clue to the puzzle is to be found
in a brief reflection on the implications of the second
general law propounded in Chapter II. A rise in price,

UTILITY 41

it was there stated, will sooner or later diminish the
demand. This was asserted as a matter of fact, ob-
served from and confirmed by experience. But what
does it signify? To what causes is this familiar fact
to be attributed? The first stage of the answer is very
simple. The many individuals, whose purchases make
up the demand for the conunodity, will buy smaller
quantities now that the price is higher. Possibly some
of them may cease to buy it altogether; but as a rule
it would be reasonable to suppose that most people con-
tinue to buy a certain amount though a smaller amount
than hitherto. Let us turn our attention, then, to the
individual purchaser, and ask ourselves why he (or let
us say she) acts in the manner indicated. The obvious
answer is that the more she already has of anything,
the less urgently does she require a little more of it.
If she buys 6 pounds of sugar every week when the price
is 7 cents a pound, but only 5 pounds when the price is 8
cents, she shows by her action that she does not consider
that, the additional utility she will derive from buying 6
pounds a week rather then 5 pounds is worth as much as
S cents. But she shows at the same time that she thinks
it worth 7 cents. For, when the price is 7 cents, no one
compels her to buy that sixth pound. She could stop, if
she chose, at five; and it may serve to make the point
quite plain if we suppose her actually to hesitate before
she buys the sixth. She has hitherto, let us say, been
buying 5 pounds a week at 8 cents. To-day she enters
the shop and finds the price is down to 7 cents. She
asks for her customary 5 pounds; then she pauses, and a
minute later turns her order into six. What are the al-
ternatives which she has been weighing one against the

42 SUPPLY AND DEMAND

other in that momentary pause? Not the utility of the
whole 6 pounds of sugar against the total price of 42
cents. For she has already ordered the first 5 pounds;
and the decision to buy the sixth is taken independently
and subsequently. She has been sizing up the increment
of utiUty which a sixth pound would yield, and she de-
cides that this is worth the expenditure of a further 7
cents. Again, when the price was 8 cents she need not
have bought as many as 5 pounds. She could have
stopped at 4 had she chosen, and the fact that she did
buy 5 pounds shows that the increment of utility de-
rived from bu3dng a fifth pound, when she might be said
already to have 4, was worth at least 8 cents in her
judgment. „

This trite illustration enables us to lay down two
important laws relating to utility. To state them
shortly, it is convenient to employ one or two technical
terms, which, unlike every term employed hitherto,
are not very commonly used in their present sense in
everyday life. Their adoption is desirable not merely
for the sake of convenience, but because they help
to stamp clearly on the mind a most illuminating
conception, that of the "margin," which supplies
the clue to many complicated problems. The last
pound of sugar which the housewife purchased, the
fifth pound when the price was 8 cents, or the sixth
poimd when the price was 7 cents, we call the "mar-
ginal" pound of sugar. And the increment of utility
which she derives from buying this marginal pound
we call the "marginal utility" of sugar to her. We
are thus able to state the fact that the more a
person has of anything the less urgently, does he

UTILITY 43

require a little more of it, in the following formal
terms: —

V. The marginal utility of a commodity to anyone

diminishes with eveiy increase in the amount

he has.

The total utility will, of course, increase with an in-
crease in the amount, but at a diminishing rate. 'This
law is usually called The Law of Diminishing Utility.

§ 3. Relation between Price and Marginal Utility
But this is not all. We are now in a position to per-
ceive the true relation between utility and price. The
relation is one which exists not between price and total
utility, but between price and marginal utility. If we
know only that a housewife will buy weekly 5 pounds of
sugar at 8 cents per pound, but 6 pounds at 7 cents, we
know nothing of the total utility of sugar to her. We do
not know how much she might be prepared to pay
rather than go without 3 pounds, 2 pounds, or any sugar
at all. But we do know that, when she buys 6 pounds,
the marginal utility of sugar is in her judgment worth
something which does not differ greatly from the price.
We can, therefore, say in general terms that the price of
a commodity measures approximately its marginal
utility to the purchaser.

This statement is perfectly consistent with the
paradox noted above that the most useful commodities
such as bread, salt and water are very cheap. For
when we say that these commodities are supremely
useful, we mean only that- their total utility is very
great; that, rather than do without them altogether,
we would offer for them a large proportion of our means.

44 SUPPLY AND DEMAND

But we would not value very highly a small addition
to the bread, water or salt that we habitually consume;
nor would most of us feel it as a very serious depriva-
tion if our consumption of these things were curtailed
by a small percentage. In other words, their marginal
utilities are small, and it is only the marginal utility
that has any relation to price.

§ 4. The Marginal Purchaser. A possible objection
to the preceding argument deserves to be considered.
Some readers may find the picture I have drawn of
the hesitating housewife entirely unconvincing. They
may declare that her mind does not work at all in
the manner I have indicated. She will have formed
certain habits in regard to her weekly purchases of
sugar, which are connected very vaguely, if at all, with
any conscious processes of thought. She will buy so
many pounds of sugar weekly without troubhng her
head over the specific utility of the last pound she buys.
When the price falls she may, indeed, buy more; but
it will not be because she separates out and considers
by itself the ejctra utility of an additional pound. She
may buy more, because she has formed the habit of
spending so much money on sugar; and now that the
price has fallen, the same amount of money will enable
her to buy more pounds. Or, perhaps, she may be
moved by instinctive and irresistible attraction to buy
more of a thing when it is cheaper, similar to that which
inspires so many people to face with ardor the horrors
of a bargain sale. In any case the fine calculations I
have imagined convey a fantastic picture of her state of
mind. And how much more fantastic, the critic mav

UTILITY 45

continue, of the state of mind in which things of a
different kind are bought by less careful people. When,
for instance, one of us happy-go-lucky males (more
liberally supplied, perhaps, than the housewife with the
necessary cash), decides to buy a motor bicycle, or to
replenish his stock of collars or ties, does the above
analysis bear any resemblance to the actual facts? In
the case of the motor bicycle, the purchaser may, in-
deed, weigh the price fairly carefully against the pleas-
ure and benefit, though contrariwise he may be a rich
enough gentleman hardly to bother about this. But,
one motor bicycle is as much as he is at all Ukely to buy,
and what becomes, then, of the distinction between
total and marginal utility? In the case of the ties and
collars, the vagueness of many of us about the price will
be extreme. We probably have been uneasily conscious
for some time of an inconvenient shortage of these
troublesome articles and eventually will go off (or
perhaps will be sent off with ignominy) to the nearest
suitable shop to make good the deficiency. How can
we speak here with a straight face of the relation be-
tween marginal utility and price?

These are very pertinent criticisms; but they do
not make nearly as much nonsense of the notion of
marginal utility as may seem at first. The last point,
indeed, serves rather to give it a fresh aspect of much
significance. Those of us who do not bother about the
price we pay for our ties and collars owe a debt of grati-
tude, of which we are insufficiently conscious, to the
more careful people who do; as well as to the custom
which prevails in shops in Western countries (as dis-
tinct from the bazaars of the East) of charging as a

46 SUPPLY AND DEMAND

rule a uniform price to all customers. If we were the
only people who bought these things, an enterprising
salesman would be able to charge us very much what
he chose. He could put up his price, and we would
hardly be aware of it. And, as by lowering his price he
could not tempt us to buy any more, price reductions
would be few and far between. But fortunately there
are always some people who do know what the price
is, even when they are bujdng collars and ties; and who
will adjust the amount they buy in accordance with the
price. It is these worthy people who make the laws
of demand work out as we well know they do. It is
they who will curtail their consumption if the price has
fallen and it is they who constitute the seller's problem,
and help to keep down prices for the rest of us. The
rest of us — it is well to be quite blunt about it — simply
do not count in this connection. We have no cause
then to plume ourselves that we have disproved the
truth of economic laws when we declare that we seldom
weigh the utility of anything against its price. All
that this shows is that our actions are too insignificant
to be described by economic laws since they exert no
appreciable influence on the price of anything. And
this in turn shows the extreme importance of graspiog
clearly the conception of the margin. Just as it is
the marginal purchase, so it is the marginal purchaser
who matters. It is the man who, before he buys a
motor bicycle, weighs the matter up very carefully
indeed and only just decides to buy it, whose demand
affects the price of motor bicycles. It is the utility
which he derives that constitutes the marginal utility,
which is roughly measured by the price.

UTILITY 47

As to the housewife, I am not prepared to concede
that my pictm'e is in essentials very fanciful. She may
be a creature of habits and instincts like the rest of
us, but most habits and instincts affecting household
expenditure are based ultimately on some calculation,
if not one's own, and reason has a way of paying, as
it were, periodic visits of inspection, and pulling our
habits and instincts into line, if they have gone far
astray. I am not satisfied that the housewife does not
envisage the utility of a sixth pound of sugar as some-
thing distinct from the utility of the other five; she
may buy it, for example, with the definite object of
giving the children some sugar on their bread, and she
may have a very clear idea as to the price which sugar
must not exceed before she will do any such thing.
Possibly I may exaggerate. I have the profoimd
respect of the incorrigibly wasteful male for the care
and skill she displays in laying out her money to the
best advantage.

§ 5. The Business Man as Purchaser. But if the reader
still finds the picture unconvincing, let us shift the
scene from domestic economy to commerce, and sub-
stitute for the careful housewife an enterprising business
man. Now, as anyone who has a business man for his
father will have often heard him say, the vagueness and
caprice V which characterize our personal expenditure
would be quite intolerable in business affairs. There
you must weigh and measure with the utmost possible
precision. You must be for ever watching the several
channels of yoiu" expenditure, careful to see that in
none does the stream rise higher than the level at which

48 SUPPLY AND DEMAND

further expenditure ceases to be profitable. You will
not even engage tj^ists or install a telephone in youf
office without weighing up fairly carefully the number
of typists or the number of switches that it is worth
your while to have. And in deciding whether to employ
say, five typists, or six, you will not vaguely lump the
services of the whole six typists together, and consider
whether as a whole they are worth to you the wages
you must give them. You will, in the most direct and
literal manner, we%h up the additional benefit you
would derive from a sixth typist, and if that does not
seem to you equivalent to her wage, you will not engage
her, however essential it may be to you to have one or
two typists in your office. If on the other hand, the
utility of having a sixth typist seems to you worth
much more than her pay, the chances are that you will
be well advised to consider the employment of a seventh.
And so, where you stop employing further typists,
the utility to you of the last one, of the "marginal
typist" as it were, is unlikely to differ greatly from her
pay.

Now this is not a fancy picture of some remote
abstraction called an "economic man." Allowing for
the over-emphasis which is necessary to drive home the
central point, it is a bald account of the aims and
methods of the actual man of business. To ascertain
the margin of profitable expenditure in each direction,
to go thus and no further, is the very essence of the
business spirit, as the business man himseK conceives
it. When he condemns the extravagance of Govern-
ment departments, it is their lack of just this marginal
sense that he chiefly has in mind. "The lore of nicely

UTILITY 49

calculated less or more" may be rejected by High
Heaven and Whitehall, but no one can afford to despise
it ia the business world.

The transition from household to business expendi-
ture involves an extended use of the word utility, which
is worth noting. Commodities Uke bread, sugar, or
privately owned motor-cars are sometimes called
"consumers' goods" in contrast to "producers' goods,"
which comprise things such as raw materials, machia-
ery, the services of typists and so forth, which are
bought by business men for business purposes. The
line of division between the two classes is not a sharp
one, and we need not trouble with fine-spun questions
as to whether a particidar commodity should ia certain
circumstances be included under the one head or the
other. But, broadly speaking, things of the former
type yield a direct utility; they contribute directly to
the satisfaction of our pleasures or our wants. Things
of the latter type yield rather an indirect utility. Their
utility to the business man who buys them lies in the
assistance they give him in making something else from
which he will derive a profit. The utility of these
things is therefore said to be derived from that of the
consimiers' goods or services to which they ultimately
contribute. This conception of derived utility leads to
certain complications which we shall have to notice
later.

§ 6. The Diminishing Utility of Money. But one
important poiat must be emphasized in this chapter.
The utility which a business man derives from the
things which he buys for business purposes is the extra

50 SUPPLY AND DEMAND

receipts which he obtains thereby. Derived utility,
in other words, is expressed in terms of money, and the '
idea of its relation to price presents no difficultj''. But
the utility of things which are bought for personal
consumption means the satisfaction which they jdeld,
and this is clearly not a thing which is commensurable
with money. When, therefore, it is said that the prices
measure their respective marginal utilities, what exactly
is meant? What was it that the argument of § 3 went
to show? That the utility of the marginal pound of
sugar would seem to the housewife just worth the price
that she must pay for it; in other words, that it would
be roughly equal to the utility she could obtain by
spending the money in other ways. The respective
marginal utilities which she obtains from the different
things she buys will thus be proportionate to their
prices. But if she were to receive a legacy which gave
her a much larger income to spend, she might buy
larger quantities of practically every comxaodity; and,
though she would obtain a greater total utility thereby,
the marginal utility she would obtain in each direction
would be smaller, in accordance with the law of dimin-
ishing utility. The prices might not have changed;
the respective marginal utilities to her of the different
things would again be proportionate to their prices,
but they would constitute a smaller satisfaction than
before.

Thus we can only say that the prices of conmaodities
will be proportionate to their real marginal utilities,
when we are considering the different purchases of
one and the same individual. The amounts of money
which different people are prepared to pay for dif-

UTILITY 51

ferent consumers' goods are no reliable indication
of the real utilities, the amounts of hxmian satisfaction
.which they yield. Here we must take account not
only of varying needs and capacities for enjoyment,
but of the very unequal manner in which purchasing
power is distributed among the people. The cigars
which a rich man may buy will yield him an immeasur-
ably smaller satisfaction than that which a poor family
could obtain by spending the same amount of money
on boots, or clothes or milk. When, therefore, we
compare commodities which are bought by essentially
different consuming publics, their respective prices may
bear no close relation to their real utility, whether
marginal or otherwise. Thus the law of diminishing
utility applies to money or purchasing power, as well
as to particular commodities. The more money a
man has the less is the marginal utility which it yields
him; and, where the marginal utility of money to a
man is small, so also will be the real marginal utility
he derives in each direction of his expenditure. The
extreme inequality of the distribution of wealth gives
immense importance to this consideration. Its practical
implications will be discussed in Chapter V. Mean-
while, we may express the conclusions of the present
chapter by the statement that the price of a commodity
tends to equal its marginal utility, as measured in terms
of money, i. e. relatively to the marginal utility of money
to its purchaser.

CHAPTER IV

COST AND THE MARGIN OF PRODUCTION

§ 1. An Illustration from Coal. We have already
had occasion to note the symmetry which characterizes
the relations of demand and supply to price. This
symmetry was apparent throughout the argument
of Chapter II, and it was a striking feature of the
diagrams which we employed to illustrate the argument.
We shall do well to cultivate a lively sense of this
symmetry, for it will frequently save us from ignoring
factors which have a vital bearing on the problems
we are considering. We should never leave an impor-
tant feature of demand without turning to see whether
it has a counterpart on the supply side, though indeed
we may not always find one. In the last chapter we
examined the relation between utility and price, and
found that the true relation was between the price and
what we termed the marginal utility. Corresponding
to utility on the demand side is cost of production
on the supply side. The question should thus at once
suggest itself — "Can we speak appropriately of the
marginal cost of production, and wiU this serve to
make clear the relation between cost and price?" To
answer these questions, let us take one of the in-
stances in which we found that price could not be
explained satisfactorily by the bare phrase "cost of

production."

COST AND THE MARGIN OF PRODUCTION 53

An important feature of the coal industry, which
recent events have brought into sharp prominence,
is the great diversity of conditions between different
coalfields and different colUeries. We speak of rich
seams and poor seams, of fertile and unfertile mines,
and we are aware that the costs of raising coal to the
surface differ very widely in accordance with these
diverse natural conditions. Nor must we confine our
attention to the cost price at the pit-head. If we wish
to speak of cost of production as a factor determining
price, we must use the term in a broad sense to include
the transport and other charges necessary to bring
the coal to market.

In this respect also one coalfield differs greatly from
another. Some are well situated close to a large market,
or within easy reach of the seaboard; others must
incur very heavy transport charges to bring their coal
to any considerable centre of consumption. These
varying conditions lead, as we well know, to great
variations in the financial prosperity of different colhery
concerns. In Great Britain, under the abnormal
conditions which prevailed during the war, and sub-
sequently, these variations were so huge as to constitute
a most formidable embarrassment and to contribute,
more perhaps than any other single factor, to the
unrest and instability by which the industry has been
afflicted. But they are always with us, if usually upon
a more modest scale.

What, then, is the normal relation between price and
cost in the case of coal? Should we direct our attention
to the average costs over the whole industry, or the
costs incurred by the richer and better situated mines,

54 SUPPLY AND DEMAND

or, lastly, that of the poorer and worse situated?
Now, as things are, it is clear enough that no concern
will continue indefinitely productag at a loss. It may
do so for a time, rather than close down altogether,
hopiag to recoup itself later when the market has
taken a more favorable turn. But, in the long run,
taking good years with bad, it must expect to obtain
receipts sufficient not only to cover its necessary
expenditure, but to provide also a reasonable profit
on the capital employed. Of course, once the capital
has been sunk and embodied in plant and buildings,
which are of little use for any other purpose, a business
may continue for many years, with a rate of profit
far below what it had anticipated. But plant and
buildings gradually wear out, and need to be replaced;
the course of technical improvement calls continually
for fresh capital outlay, which a business in a bad way
is reluctant to undertake. The tendency, therefore,
when profits rule low over a considerable period, is
for the plant to fall gradually into disrepair and
obsolescence, and finally for the business to disappear.
We can thus include an ordinary rate of profit under the
head of cost of production, and say with substantial
accuracy that for no business can this cost for long
exceed the price if the business is to continue to exist
If then the relatively poor and badly situated mines
are to be worked, the price of coal, taking good years
together with bad, must cover the costs at which these
mines can produce. If the price rules lower than this,
sooner or later they will close down, and we will be left
with a smaller number of mines, among which great
variations of conditions will still prevail. Once more.

COST AND THE MARGIN OF PRODUCTION 55

the price must cover the cost incurred by the least
profitable of these remaining mines, unless their number
is still further to be diminished. Thus we can conceive
of a "margin of production" which will shift backwards
to more profitable or forwards to include less profitable
mines, according as the demand for coal contracts
or expands. But, wherever this margin may be, there
is no escaping the conclusion that it is the cost of
production of the "marginal mines," of those that is
to say which it is only just worth while to work, to
which the price of coal will approximate.

It follows that there is no real connection between
price and cost of production throughout the industry
as a whole. It follows incidentally that those concerns
which can market their coal at an appreciably lower
cost than the marginal concerns, are likely to reap
more than an ordinary rate of profit, though royalties
may absorb part of the excess.

§ 2. The Various Aspects of Marginal Cost. This
relation cuts much deeper than the particular system
under which the mines are at present owned and worked.
If, for instance, we supposed that the various mines
were amalgamated together in a few giant concerns,
each of which comprised some of the richer and some
of the poorer mines, the preceding argument would
need to be recast in form, but its substance would be
unaffected. For though a great coal trust could in a
sense afford to sell at a price lower than the marginal
cost, setting its losses on the poorer against its gains
on the better pits, is it likely it would do so? Why
should it dissipate its profits in this way? It is clearly

56 SUPPLY AND DEMAND

more reasonable to suppose that it would close down
the poorer pits (unless it could advance the price of
coal), and thereby maintain its profits at a higher figure.
If, indeed, the mines were nationalized the deliberate
policy might be pursued of selling coal at a price which
left the industry no more than self-supporting as a
whole. Some coal might thus be sold at less than its
cost price, and the selling price would conform roughly
to the average cost. But such a policy, though in special
circumstances it might be justified, would represent a
very dangerous principle, which could not be applied
widely without the most serious results. Nothing
could be more fatal to any enterprise, whether it be
in the hands of an individual, a joint-stock company,
a State department, or a Guild, than that the manage-
ment should content themselves with results which
in the lump seem satisfactory, and regard losses
here or there with an indifferent eye. That way lies
stagnation, waste, progressive inefficiency and ultimate
disaster. To inquire searchingly into every nook and
cranny of the business, to construct, as it were, for
each part a separate balance-sheet of profit and loss,
to expand in those directions where further develop-
ment promises good results, and to curtail activity
where loss is already evident, is the very essence of good
management. Here, it will be observed, we are using
language very similar to that in which we described
the principles which govern a business man's expendi-
ture. The resemblance is inevitable and significant, for
we are dealing here with what is essentially another
aspect of the same thing. The object is to secure that
nowhere does expenditure fail to yield a commensurate

COST AND THE MARGIN OF PRODUCTION 57

return. This we express, when we consider a business in
its aspect as a consumer, by saying that its consumption
of anything will not be carried beyond the point at
which the marginal utility exceeds the price it will
have to pay. When we consider it as a producer, we
say that its production of anything will not be carried
beyond the point at which the marginal cost exceeds
the price it will obtain.

§ 3. The Dangers of Ignoring the Margin. This at least
is the general rule. A business may decide deliberately
to sellpart of its output below cost, because, for in-
stance, this will serve as an advertisement, bring it con-
nections, and enable it to obtain a larger profit at a later
date, or inomediately on other portions of its sales. In
so acting, it recognizes that the price obtained for a
thing may be an inadequate measure of the real return
it yields. In the same way, though for different reasons,
a nationalized coal industry might conceivably be
justified in selling some coal below cost price, be-
cause, let us say, it held that the price which the
immediate purchasers were willing to pay was an
inadequate measure of the utility of coal to the com-
munity as a whole. But in all such cases it is essential
to be very clear as to what exactly you are doing; so
that you may be at least moderately clear as to whether
the policy is well advised. It may be sound enough to
lose on the swings and make good this loss on the
roundabouts, but only if your loss on the swings helps
you to a larger profit on the roundabouts. If you
would get the same return on the roundabouts in any
case, it would be better to cut the swings out altogether.

58 SUPPLY AND DEMAND

So, if you are directing the policy of a nationalized coal
industry, and decide to make a loss on a portion of
your sales, you will need to know that the indirect
benefit which the community will derive from this
particular part of your coal output is worth the loss
which you incur. You will certainly come to grief, if
you pursue a vague ideal of lumping all results together,
and regarding a profit somewhere as a sufficient excuse
or a positive reason for making a loss elsewhere.

It is quite true that in big undertakings, where there
are large standing charges, and where the organization
possesses some of the characteristics of an integral
whole, it is not easy to measure accurately the specific
costs which should be assigned to any particular
portion of the output. But this difficulty is one of the
most serious weaknesses of large imdertakings; precise
detailed measurement is the great prophylactic of
business efficiency, and, where it is lacking the bacilli
of waste will enter in and multiply. So clearly is this
recognized, that the development of large scale business
has led to the evolution of new methods of accountancy,
designed to make detailed mensuration possible. We
have most of us heard of them vaguely under such
names as "comparative costings," but too few of us
appreciate their full significance. It is hardly too
much to say that the issue as to whether the size of the
typical business unit will continue to become larger and
larger, or whether it has already overshot the point of
maximum efficiency will turn largely upon the capacity
of accountancy to supply large and complex under-
takings with more accurate instriiments of detailed
financial measurement.

COST AND THE MARGIN OF PRODUCTION 59

§4. A Misinterpretaiion. The price, then, of a com-
modity tends roughly to equal its marginal cost of
production; and this marginal cost (in perfect sym-
metry with what we observed as regards marginal
utility), may be conceived as applying either to the
marginal producer or to the marginal output of any
producer. In the former aspect it is open to a mis-
interpretation, against which it will be well to guard.
Some advocates of socialism have argued, as one of the
counts in their indictment of the present industrial
system, that the price of a commodity is determined by
the cost at which the least efficient concern in the
industry can produce. They say, in effect, "Under
the present competitive regime, you have to pay for
everything you buy a price which far exceeds the
necessary cost to a concern which is managed with
ordinary ability. For, as economic theory has shown,
it is the cost of the marginal concern, i. e. the concern
managed by the most incompetent, and half-witted
fellow in the trade; it is the cost incurred by him,
together with a profit on his capital, that the price has
got to cover. The producer of no more than average
capacity is therefore making out of you a surplus profit,
which would be quite unnecessary in any well-arranged
society." Such an argument is a gross caricature of
the marginal conception. The half-witted incompetent
will, as we know well enough, speedily disappear under
the stress of competition, and his place will be taken
by more efficient men. There is an essential difference
between him and the "marginal coal naine" of which
we spoke above. For the probabilities are that of the
coal resources, whose existence is clearly known, the

60 SUPPLY AND DEMAND

more fertile and better situated parts will already be in
process of exploitation; and there is not likely, there-
fore, to be a supply of substantially better seams which
can be substituted for the worst of those in actual use.
There is likely, on the other hand, to be available a
supply of decent business capacity which can be substi-
tuted for the most inefficient of existing business men.
The marginal concern, in other words, must be con-
ceived as that working under the least advantageous
conditions in respect of the assistance it derives from
the strictly limited resources of nature, but under
average conditions as regards managerial capacity and
human qualities in general. Thus in agriculture we can
speak of a marginal farm, which we should conceive as
the least fertile and worst situated farm which it is just
worth while to cultivate (of which more will be said
when we come to the phenomenon of rent), but we
must assume it to be cultivated by a farmer of average
ability. {a"

§ 5. Some Consequences of a Higher Price Level. The
foregoing controversy will be of service to us, if it
makes clear the manner and the spirit in which the
marginal conception should be handled. It should be
regarded not as a rigid formula which we can apply
to diverse problems without considering the special
features they present, but rather as a signpost which
will enable us to find our way, a compass by which we
may steer between the shoals of triviality and sophistry
to the crux of any problem with which we have to deal.
Let us illustrate its practical uses by an example which
is of great interest and far-reaching practical importance

COST AND THE MARGIN OF PRODUCTION 61

at the present day. As has been already observed, the
war has left behind it in all countries a great and almost
certainly permanent increase in nominal piu-chasing
power. Since the armistice prices have moved upwards
and downwards with unprecedented violence; and it
would be very rash to prophesy the precise level at
which they will ultimately settle (using that word with
considerable relativity). But, for reasons for which the
reader is referred to Volmne II in this series, it is safe
enough to say that the general level of post-war will
greatly exceed that of pre-war prices. Now this wUl
apply not only to consumers' goods like milk and
clothes, or to raw materials like pig-iron and cotton,
but in very much the same degree to things like
factories and machinery. Things of this last type are
sometimes called "capital goods," because it is in them
that a large part of the capital of a busiaess is embodied.
Now the fact that it wiU cost much more than it did
before the war to construct fresh capital goods, has a
significance which very few people appreciate. An
existing factory cost, let us say, $500,000 to build and
equip with machinery before the war. To construct a
similar factory to-day would cost, let us assume (it
is probably a moderate assumption) $1,000,000. Sup-
pose 10 per cent to be the gross profit that is necessary
to attract capital to the particular industry. Then it
will not pay to construct this new factory imless the
trade prospects point to the probabihty of a profit of
about $100,000 per annum. But if the old factory is
equally well managed, it too should be able to earn this
$100,000, which upon the capital actually sunk would
represent a rate of 20 per cent. The particular figures

62 SUPPLY AND DEMAND

given are, of course, purely illustrative; the con-
clusion to which they point is that, if new enterprises
are to be undertaken, pre-war enterprises are likely to
yield a rate of profit, on their fixed capital at least,
increased in rough proportion to the price-level. Of
course, in years when trade is bad, the factory which
dates from pre-war times will not earn a profit of this
kind, it may very likely make an actual loss. At those
times it is very certain that few new factories will he
erected. But it is difficult to reconcile a condition of
trade activity, in which the constructional industries
are busily employed, with a rate of profit to pre-war
businesses on the fixed part of their capital of a lesser
order of magnitude than has been indicated. It makes
no difference, it should be observed, whether we suppose
the new enterprises to take the form of starting of
new concerns or extending old ones; in neither case
will they be imdertaken, imless there is reason to
■expect an adequate return on the capital which they
require at post-war constructional prices. High profits
(taking always good years together with bad) on capital
sunk before the war in buildings and machinery are
thus a likely consequence of an increase in the price-
level.

This fact is, indeed, the counterpart or complement
of another phenomenon with which we are more
familiar. While prices are actually rising, profits, as we
have come to recognize, necessarily rule high, because
every trader or manufacturer is constantly in the
position of selling at a higher price-level, stock which
he purchased, or goods made from materials which he
pvurchased at a lower level. He thus acquires an ab-

COST AND THE MARGIN OF PRODUCTION 63

normal profit on his circulating capital, which is
essentially similar to the profit on fixed capital, which
we have just examined. The difference is that the
former profit is crowded into the years when prices are
actually on the increase, and thus is very noticeable
indeed; while the latter profit continues to accrue in
smaller instalments after prices have settled down, as
it were, at the higher level, and is not exhausted until
the buildings and machinery have become obsolete.
But the two profits are essentially similar, and in the
long run should be commensurate. In the one case,
stock can be sold for a large profit, because it cannot
be replaced except at a higher price; in the other case,
plant and buildings yield a higher income because they
cannot be replaced except at a higher price. Indeed,
if the owners choose, the plant and building can, like
the stock, be sold at their appreciated value, as has been
widely done by the owners of cotton naills ia Great
Britain since the armistice.

There is nothing in these considerations that should
surprise us, or even shock our moral sense. For what
they have indicated is an increase of money profits in
rough proportion to the price-level, so that the aggre-
gate profits will represent about as much real income as
before.^ The conclusion therefore amounts to no more
than this, that you cannot alter fundamentally the
distribution of wealth between labor and capital by
merely inflating the currency, or otherwise juggling

' Assuming that the rate of interest has remained unaltered.
In fact it has greatly increased since pre-war days, and this points
to a still further increase of money profits, and an increase in the
real income which they represent. See Chapter VIII, p. 138.

64 SUPPLY AND DEMAND

with the price-level. And this is only what we should
expect, if there are any laws of distribution of sufficient
importance and permanence to justify the many vol-,
umes which have been devoted to them.

But this somewhat tame conclusion does not make
it any less important to grasp clearly the significance
of the appreciation in the value of capital goods. A
failure to realize it lies at the root of our bewildered
muddling of many crucial problems of the day. In
the matter of housing, for instance, we know we cannot
build houses at less than two or three times their pre-
war cost, and yet we cannot endure to see the owners
of pre-war houses obtaining a commensurate increase
of rent. And so, in Great Britaia, we pass Rent Restrio-
tion Acts, and Housing Acts, and then, in a fit of
economy we suspend the latter, and let the former
stand, while the housing shortage becomes steadily more
acute. When we hand the railways back from State
control to private hands, our horror at the idea of the
companies receiving larger money profits than they did
before the war leads us to lay down principles for the
fixing of fares and freight charges, which take no
account of post-war construction costs; and then, in
alarm lest we may have thereby made it unprofitable
for the companies to spend a single penny of fresh
capital upon further development, we seek to provide
for capital expenditure by cumbrous and dubious
expedients. Doubtless we shall muddle through some-
how with such policies: and, public opinion being what
it is, they may perhaps have been about the best
policies that were practiable. But the problems would
have been easier to handle, if the public generally were

COST AND THE MARGIN OF PRODUCTION 65

a little less disposed to think in terms of averages, and
a little more in terms of margins, if we all of us instiao-
tively realized that the cost that really matters is the
cost at which additional production is profitable under
the conditions ruling at the time, or in the immediate
future.

§ 6. General Relation between Price, Utility and Cost.
Let us conclude this chapter by sununing up the con-
clusions which have emerged as to the relations of
utility and cost to price.

The price of a commodity is determined by the con-
ditions of both supply and demand; and neither can
logically be said to be the superior influence, though
it may sometimes be convenient to concentrate our
attention on one or other of them. The chief factor on
which the conditions of demand depend is the utility
(as measured iq terms of money). The chief factor
on which the conditions of supply depend is the cost
of production (again as measured in terms of money).
The prevailing trend towards an equilibrium of demand
and supply can thus be expressed as follows: —

VI. A commodity tends to be produced on a scale
at which its marginal cost of production is
equal to its marginal utility, as measured in
terms of money, and both are equal to its
price.

CHAPTER V

JOINT DEMAND AND SUPPLY

§ 1. Marginal Cost under Joini Supply. Several refer-
ences have been made above to joint products, a rela-
tion which it will be convenient now to describe as that'
of Joint Supply. Our sense of synunetry should make
us look for a parallel relation on the side of demand; and
it is not far to seek. There is a "joint demand" for
carriages and horses, for golf clubs and golf balls, for
pens and ink, for the many groups of things which we
use together in ordinary life. But the most important
instances of Joint Demand are to be found when we pass
from consumers' to producers' goods. There, indeed,
Joint Demand is the xmiversal rule. Iron ore, coal and
the services of many grades of operatives are all jointly
demanded for the production of steel; wool, textile
machinery and again the services of many operatives
are jointly demanded for the production of woollen
goods (to mention in each case only a few things out
of a very extensive list). Now we have already noted
that, when commodities are jointly supplied, there is
an obvious diflEiculty ia allocatiag to each of them its
proper share of the joint cost of production. There is
a similar difficulty in estimating the utiUty of a com-
modity which is demanded jointly with others. Thus,
the utihty of wool is derived from that of the woollen
goods which it helps to make. But the utility of the
factories, the machinery and the operatives employed in
the woollen and worsted industries is derived from pre-

JOINT DEMAND AND SUPPLY 67

cisely the same source. How much, then, of the utility of
woollen goods should be attributed to the wool and how
much to the textile machinery? Can we make any sense
of the notion of utility as applying to one of these things,
taken by itself? And, if not, how can we explain the
price .of a thing like wool in terms of utility and cost,
since we cannot disentangle its cost from that of mutton,
nor its utiUty from that of a great variety of other things?
Here the conception of the margin enables us to
grapple with a problem which would otherwise be
insoluble. For, while it is impossible to separate out
the total utility and cost of wool, it is not impossible
to disentangle its marginal utility and its marginal cost.
The proportion in which wool and mutton are supplied
cannot be radically transformed; but it can be varied
within certain limits, by rearing, for instance, a different
breed of sheep. Variations of this kind have been an
important feature of the economic history of Austral-
asia, where sheep farming is the leading industry. Be-
fore the days of cold storage, Austraha and New Zealand
could not export their mutton to European markets,
though they could export their wool. Wool was accord-
ingly much the most valuable product; the mutton was
sold in the home markets, where, the supply being very
plentiful, the price was very low. In the circumstances,
the Australasian farmers naturally concentrated on
breeding a variety of sheep whose wool-yielding were
superior to their mutton-yielding qualities. The
development of the arts of refrigeration led in the
eighties to an important change. It became possible to
obtain relatively high prices for frozen mutton in over-
seas markets. There was, therefore, a marked tendency,

68 SUPPLY AND DEMAND

especially in New Zealand, to substitute, for the merino,
the crossbred sheep which yields a larger quantity of
mutton and a smaller quantity of wool of poorer quality.
Now if we calculate the cost of maintaining the number
of merino sheep which will yield a given quantity of
wool, and calculate the cost of maintaining the larger
number of crossbred sheep which will be required to
yield the same quantity of wool (allowing for differences
of quality) the extra cost which would be incurred in the
latter case must be attributed entirely to the extra
mutton that would be obtaiaed. This extra cost we can
regard as constituting the marginal cost of mutton.
So long as this marginal cost falls short of the price
of mutton, it will be profitable to extend further the
substitution of crossbred for merino sheep. The process
of substitution will in fact be continued imtil we reach
the point at which the marginal cost is about equal to
the price. Similarly by starting with the numbers of
merino and crossbred sheep which would yield the same
quantity of mutton, we can calculate the marginal cost
of wool; and again the tendency will be for this mar-
ginal cost to be equal to the price.^

1 It may be found difficult to grasp this point when stated in
general terms. The following arithmetical example may make it
plainer: —

Suppose a merino sheep yields 9 units of mutton and 10 units of
wool.

Suppose a crossbred sheep yields 10 units of mutton and 8 units
of wool.

Suppose, further, that a merino sheep and a crossbred sheep
each cost the same sum, say, for convenience, £10, to rear and
maintain; and that there are no special costs assignable to the
wool and the mutton respectively, as, of course, in fact there are.

Then 10 merino sheep, yielding 90 units of mutton +100 units

JOINT DEMAND AND SUPPLY 69

§ 2. Marginal Utility under Joint Demand. On the side
of demand there exist as a rule similar possibilities of
variation. Some machinery, some labor, some mater-
ials of various kinds, are all indispensable in the produc-
tion of any manufactured commodity. But the propor-
tions in which these factors are combined together can
be varied, and are frequently varied in practice as the
result of the ceaseless pursuit of economy by business
men. To produce pig-iron, you need both coal and
iron ore; but, if coal becomes more costly, it is possible
to economize its use. Machinery and labor must be

of wool, cost £100; while 9 crossbred sheep, yielding 90 units of
mutton+72 units of wool, cost £90.

Hence you could obtain an extra 28 units of wool for an extra
cost of £10, by maintaining 10 merino sheep rather than 9 cross-
bred sheep. The marginal cost of wool is thus £^ per unit.

Similarly 8 merino sheep, yielding 72 units of mutton +80 units
of wool, cost £80; while 10 crossbred sheep, yielding 100 units of
mutton +80 units of wool, cost £100.

Hence you could obtain an extra 28 units of mutton for an extra
cost of £20, by maintaining 10 crossbred sheep in place of 8 mer-
inos. The marginal cost of mutton is thus £f§- per unit.

So long as the price obtainable for wool exceeds £^, and that
obtainable for mutton does not exceed £f § per unit, it wiU pay to
substitute merino for crossbred; and conversely. If the price of
wool exceeds £^^ and the price of mutton also exceeds £f f , it wiU
be profitable to expand the supply of both breeds, until as the
result of the increased supply, one of the above conditions ceases
to obtain. Conversely, if the prices of both products are less than
the figures indicated, sheep farming of both kinds wiU be re-
stricted. The resultant of the processes of expansion or restric-
tion, and substitution, wlQ be that, unless one of the breeds is
eliminated, the prices of mutton and wool will equal their respec-
tive marginal costs. These marginal costs may, of course, alter
as the process of substitution extends. For the relative cost of
maintaining merinos and crossbreds will not be the same for
every farmer. Here again it is the costs at the "margin of sub-
stitution" that matter.

70 SUPPLY AND DEMAND

used together, in some cases in proportions which are
absolutely fixed. But there is in nearly every industry
a debated question as to whether the introduction of
some further labor-saving machine would be worth
while, or some improved machine which would represent
the substitution of more capital plus less labor for less
capital plus more labor. A farmer can cultivate his
land, to use a common expression, more intensively or
less intensively; in other words, he can apply larger
or smaller quantities of capital and labor (the propor-
tion between which he can also vary) to the same
amount of land. The problem is essentially the same as
that of the substitution of the crossbred for the merino.
We can take the Various possible combinations of the
factors of production, and contrast two cases in which
different quantities of one factor are employed, together
with equal quantities of the others. The extra product
which will be yielded in the case in which the larger
quantity of the varying factor is employed can then be
regarded as the marginal product (or marginal utility)
of the extra quantity of that factor; and we can say
that the employment of this factor will be pushed
forward to the point where this marginal product
will be roughly equal to the price that must be paid
for it. We can thus lay down the most important
proposition that the relation between marginal utility
and price holds good generally of the ultimate agents
of production; that the rent of land, the wages of
labor, and, we can even add, the profits of capital tend
to equal their (derived) marginal utilities, or, as it is
sometimes expressed, their marginal net products.
Whenever, therefore, the proportions in which two or

JOINT DEMAND AND SUPPLY 71

more things are produced or used together can be
varied, the relations of joint supply and joint demand
are perfectly consistent with a specific marginal cost
and marginal utiUty for each commodity.

§ 3. A contrast between Cotton and Cotton-seed, and
Wool and Mutton. But it sometimes happens that such
variations cannot be made. Thus, it has not been
found possible (so far as I am aware) to alter the
proportions in which cotton lint and cotton-seed are
yielded by the cotton plant. Roughly speaking, you
get about 2 pounds of cotton-seed for every 1 pound of
cotton liat (or raw cotton), and though this proportion
may vary somewhat from plantation to plantation, it is
upon the knees of the gods, and not upon the will of the
planter that the variation depends. We cannot, there-
fore, speak with accuracy of the separate marginal costs
of raw cotton and cotton-seed. It is true that some
plantations are so far distant from ajiy seed-crushing
mill that it is not worth while to sell the seed as a
commercial product; and it might seem, therefore,
as though we might regard the entire costs of cotton
growing on such plantations as constituting the mar-
ginal costs of raw cotton. But planters, so situated,
derive a considerable value from their cotton-seed by
using it as fodder for their live stock or as a manure.
You can, of course, argue that proper allowance is
automatically made for this factor, as a deduction from
the costs of raw cotton, when you add up the expenses
of the plantation. In the same way you can deduct the
price which a planter who sells his cotton-seed obtains
for it, from the total costs of the plantation, and call the

72 SUPPLY AND DEMAND

remainder the costs of the raw cotton. But this is
really to reason in a circle. For in either case the
magnitude of the deduction depends on the marginal
utility of the cotton-seed. And the notion of the cost
of anything becomes blurred and blunted if we so use
it that it must be deduced from the utility of something
else, which is not an _agent in the production of the
thing in question.

This point is not merely an academic one. It means
that we cannot explain the relative prices of cotton
lint and cotton-seed in terms of cost at all, whether
marginal or otherwise. The influence of cost will be
confined to the sum of the prices of the two things.
Upon this sum it will exert precisely the same influence
as it exerts upon price in general, by affecting the total
quantities of the two things that will be supplied. But
upon the distribution of this sum between lint and
seed, cost will exert no influence whatever, because it
cannot affect the proportions in which they are supplied.
It may assist some readers if I state the matter in more
concrete terms. Cost of production will be one of the
factors which will result in the production of an annual
cotton crop in the United States of, let us say, 10 million
tons of seed cotton. This crop will yield roughly 6|
milUon tons of cotton-seed, and 3^ milHon tons (or
rather more than 13 miUion bales) of lint. The com-
bined price received by the planter of (let us say) 14.4
cents for 1 pound of lint plus 2 pounds of seed should
correspond roughly to the margioal joint costs of pro-
duction. But the factor of cost has no influence at all
in determining that this combined price is made up of
a price of 12 cents per poimd for Unt, and only 1.2 cents

JOINT DEMAND AND SUPPLY 73

per pound (or $24 per ton) for cotton-seed. To account
for this we must rely entirely upon demand. We can
say, shortly, that the respective prices must be such as
will enable the demand to carry off 6| million tons
of seed, and 3| million tons of raw cotton. Or we
can go further and say that the marginal utility of a
pound of raw cotton, when 3|- million tons are sup-
plied, is ten times as great as that of a pound of seed
when 6f roUUon tons are supplied.

If accordingly the demand for cotton-seed were to
expand considerably owing, say, to the discovery of
some new use for the oil, which is its most valuable con-
stituent; the effect would be first a rise in the price of
cotton-seed, and, subsequently, by stimulating cotton
growing, a more plentiful supply and a lower price for
raw cotton. And so far at least as the increased supply
is concerned, this must necessarily be the effect, "other
things being equal"; though, to be sure, it might be
outweighed and obscured by other influences such as the
boll-weevil. But it is not the case that an increased
demand for mutton must necessarily increase the supply
or lower the price of wool; and it is most unlikely
to do so in any similar degree. For, here, the separate
marginal costs of the two things exert their influence.
An increased demand for mutton will stimulate sheep
farming, but it will also stimulate the substitution of
crossbred for merino breeds; and the resultant of these
two opposite tendencies upon the supply of wool is
logically indeterminate. As a matter of history we know
that the development of cold storage in the eighties
(which we may regard for the present purpose as equi-
valent to an increased demand for Australian mutton)

74 SUPPLY AND DEMAND

caused considerable perturbation in the woollen and
worsted industries of Yorkshire. They were faced with
a dwindling supply and a soaring price of merino wool;
and the adaptability with which they met the situation,
and won prestige for the crossbred tops, and yams and
fabrics, to which they largely turned is a matter of
just pride in the trade to-day. The fact, however, that
this alteration in the supply of wool was a matter not
only of quantity but of quality, while it takes nothing
from the substance of the preceding argument, makes
it difficult to draw a clear moral, bearing on the present
issue, from this incursion into history.

§ 4. The Importance of being Unimportant. The above
contrast between cases in which variation is possible,
and those in which it is not possible, is reproduced with
a heightened significance when we turn back to joint
demand. The cases are perhaps less common in which
it is impossible to alter the proportions in which different
conunodities are jointly demanded, but there are many
cases in which it is not nearly worth while to do so
(and this amounts to very much the same thing).
Cases of this sort are especially hkely to occur when we
are dealing with a commodity which accounts for only
a tiny fraction of the costs of the industry which is its
chief consumer. Sewing cotton, for example, is jointly
demanded, with many other things, by the tailoring
and other clothing trades; but the money which these
trades spend on sewing cotton is so small a part of
their total expenditure, that no ordinary variation in
its price is likely to make it worth while to study the
ways and means of using it in smaller quantities. When

JOINT DEMAND AND SUPPLY 75

sewing cotton is bought by the domestic consumer,
considerations which are fundamentally the same,
though somewhat different in form, point to a similar
conclusion. It is thus very difficult to assign to sewing
cotton a specific marginal utility. This difficulty is of
great importance in connection with the possibilities
of monopolistic exploitation. For it means that the
demand blade of the scissors upon which we rely to cut
off excrescences of price is blimted, and if accordingly
the producers constitute a strong enough combination
to control the supply blade, they will possess an unusual
power of advancing their selling prices as they choose.
I am far from suggesting that Messrs. J. & P. Coats
are to be condemned as an extortionate monopoly.
On the contrary, during 1919, when the profits in highly
competitive industries like the main branches of the
cotton and woollen trades, soared exuberantly, the
record of this concern seems to me one of distinct
moderation. But the present point is that they possess
an exceptional power to fix the price of sewing cotton
as they choose, and that this is attributable in no small
degree to the fact that sewing cotton constitutes an
essential but relatively trifling item in the expenses of
the processes in which it is employed.

Perhaps the point will be made clearer if we turn
from the selling prices of commercial products, in regard
to which there is a strong and not ineffective public
sentiment against "profiteering," to the remuneration
of different classes of labor. With an instinctive dis-
position towards megalomania, it is often claimed in
Great Britain that the miners, being a very numerous
and well-organized body of workpeople, were in a

76 SUPPLY AND DEMAND

stronger strategic position than most workpeople
for exacting the remuneration they desire. It is
quite true that a stoppage of work in the coal in-
dustry causes us a high degree of inconvenience,
and temporary concessions may thereby be obtained
which might otherwise have been refused. But this
is a dubious advantage, and we grossly exaggerate^
its real importance. The truth is that the strategic
position of the miners in regard to wages questions is
by no means strong. For their wages constitute a very
large percentage of the cost of coal; and the price of coal
in its turn is a most important element in the costs of
many of the industries which are its principal con-
sumers. Great Britain, moreover, is far from possessing
a monopoly of coal. If, accordingly, the wages of the
miners are temporarily pushed up to a high point, the
result will certainly be a diminished demand for British
coal, which will lead before long to their fighting a losing
battle to maintain the concessions they have won.
Contrast their position with that of the steel smelters,
whose wages (high though the Wage rates are) constitute
a very small percentage of the costs of steel production,
and we must agree I think that we have in this distinc-
tion the main reason why the steel smelters, though
they hardly ever go on strike, have as a rule been
able to do so much better for themselves than the
miners.

When a commodity or service is such that an appreci-
able alteration in its price has only a shght effect upon
the quantity demanded, the demand is said to be
inelastic. Conversely, when b, small change va. price
greatly alters the quantity demanded, we call the

JOINT DEMAND AND SUPPLY 77

demand elastic. In the former case, it is worth nothuig,
a larger aggregate sum of money wiU be spent upon the
thing when its price is high than when it is low, while
the opposite is true in the latter case. This distinction
is of considerable importance in connection with many-
problems (e. g. of taxation); and the terms, elastic
demand and inelastic demand, are worth remembering.
We may thus express the above conclusions by saying
that the demand for sewing-cotton is highly inelastic,
and that the demand for coal miners is more elastic than
that for steel smelters.

§ 5. Capital and Labor. Cases in which it is imprac-
ticable to make any variation in the proportions in
which different things are used together are, however,
the exception rather than the rule. Where variation
is possible, we are confronted with an uncertainty as to
the way in which an increased supply of one thing will
react on the demand for another, similar to our uncer-
tainty as to whether an increased demand for mutton
would augment or diminish the supply of wool. It is,
for instance, of the highest importance to give a clear
answer, if we can, to the question whether an increased
supply of capital will increase the demand for labor.
The chief effect of an increased supply of capital is to
facilitate the extended u^ of expensive machines: to
some extent these machines will increase the demand
for labor; to some extent they will be substituted for
it. Which of these two tendencies will outweigh the
other we cannot be absolutely sure. But fortxmately
we can be far more nearly sure than was possible in the
analogous case of wool and mutton. An increase in the

78 SUPPLY AND DEMAND

supply of capital increases the demand for the com-
modities, from which the demand for labor is derived,
in both the senses discussed in Chapter II. First it
makes them cheaper to buy, and thus increases the
quantity that will be bought. It is this that is parallel
to the effect of an increased demand for mutton in
making it more profitable to breed sheep. But it also
serves to increase the purchasing power with which to
buy commodities, because it increases the aggregate
real wealth of the community, and it thus serves to
raise the whole demand curve. This last consideration
is so important as to make it overwhelmingly probable,
apart from the evidence of history, that an increase in
the supply of capital (and the same may be said of an
increase in the supply of the other agents of production)
will on balance increase the demand for labor. The
evidence of history points to the same conclusion. The
history of the last himdred years displays an unprece-
dented accumulation of capital, and an unprecedented
extension of machinery, associated with an unprece-
dented improvement in the standard of Kviag through-
out the whole commtmity. This is powerful testimony
in favor of the view that an increase ia the supply of
capital and the use of machinery will usually enhance on
balance the demand for labor. Moreover, though this
is not conclusive, there is little room for doubt that an
obstructive attitude towards the extension of machinery
in a particular coimtry, or a particular district, is mis-
guided. For its effect must be to make production
more costly there than it is elsewhere, and to lead,
slowly perhaps, but very surely, to the transference of
the industry to other regions.

JOINT DEMAND AND SUPPLY 79

§ 6. Conclusions as to Joint Supply and Joint Demand.
Here, however, we are beginning to digress. Let us
sum up in a general form our conclusions as to the way
in which changes in the supply or demand of a commod-
ity react upon the demand or supply of the other things
with which it is jointly demanded or supplied. Every-
thing turns, as we have seen, on the possibility of
variation in the proportions in which the things are
used or produced together; and this, it is also clear,
is a matter of degree. Our conclusions, therefore, had
best take the following form: —

Vn. When two or more things are jointly de-
manded, in proportions which cannot easily
be varied, the tendency will be for an increase
(or decrease) in the supply of one of them to
increase (or decrease) the demand for the
others. These results will be more certain,
and more marked, the more difficult it is to
vary the proportions in which the things are
used.

Similarly, when two or more things are
jointly supplied, in proportions which cannot
easily be varied, the tendency will be for an
increase (or decrease) in the demand for one
of them to increase (or decrease) the supply
of the others. These results again will be
more certain and more marked, the more
difficult it is to vary the proportions in which
the things are supplied.

§ 7. Composite Supply and Composite Demand. Joint
Demand and Joint Supply do not complete the list of

80 SUPPLY AND DEMAND

relations between the demand and supply of different
things. Between tea and coffee, or beef and mutton
there is a relation of a different kind. These things are
in large measure what we call "substitutes" for one
another. An increased supply, and a lower price of
mutton, will probably induce us to consume less beef.
This relation it is convenient to describe as Composite
Supply. Beef and mutton make up a composite supply
of meat; tea and coffee a composite supply of a certain
type of beverage. For any group of things, between
which the relation of Composite Supply exists, we can
say, with complete generality, that an increased supply
of one of them will tend to diminish the demand for
the others. Parallel to the relation of Composite
Supply is that of Composite Demand. There are fre-
quently several alternative uses in which a commodity
or service can be employed; and these alternative uses
make up a composite demand for the thing in question.
Thus railways, gasworks, private households and a
great variety of industries contribute to a Composite
Demand for coal. It is worth noting that there is fre-
quently an association in practice between Joint De-
mand and Composite Supply on the one hand; and be-
tween Joint Supply and Composite Demand on the
other. Wool and mutton, for instance, we have de-
scribed as an instance of Joint Supply; but, in so far as
the proportions of wool and mutton can be varied, we
can regard these things as constituting a Composite
Demand for sheep. And this conception may help us
to retain a clearer and more orderly picture of the prob-
lems we have discussed above. We can regard the fact
that wool and mutton are produced together as their

JOINT DEMAND AND SUPPLY 81

Joint Supply aspect, and the fact that these proportions /
can be varied as their Composite Demand aspect; and
the question as to whether an increased demand for
mutton will increase the supply of wool turns upon
whether the former aspect is more important than
the latter. Similarly labor and machinery, employed
together for the same purpose, form an instance of
Joint Demand; but in so far as they can be substituted
for one another, they constitute a Composite Supply of
alternative agents of production.

These four relations of Joint Demand, Joint Supply,
Composite Demand and Composite Supply are well
worth remembering and distinguishing from one
another. They are of immense importance in every
branch of economic affairs. There are hardly any
economic problems upon which we are fitted to express
an opinion, unless we have a lively sense of the far-
reaching ramifications of cause and consequence, of the
subtle and often unexpected interconnections between
different industries and different markets. To gape at
these complexities in a confused stupor is as foolish as
it is to ignore them. But confusion and stupor are only
too likely to represent our final state of nund, if we
attempt to deal with these complications, one by one
as they occur to us, in a piecemeal and haphazard
fashion. We need a clear method, a systematic plan
by which we may search them out, and fit them iato
place. The four relations which we have enumerated
supply us with such a plan and method. For they
represent something more than a series of pompous
names for familiar notions. They constitute a classifi-
cation of the various ways in which the demand and

82 SUPPLY AND DEMAND

supply of one thing can affect the demand and supply of
others; a classification which is exhaustive when we
add the relation of derived demand, and an analogous
relation on the supply side which we must now notice.

§ 8. Ultimate Real Costs. Just as the utiUty of "pro-
ducers' goods" is derived from that of the "con-
sumers' goods" which they help to make; so the
cost of any commodity is derived from the cost of the
things which help to make it. Moreover, just as we
recognize that the utility of "consumers' goods" lies
at the back of all demand, and constitutes the ultimate
end of all production; so we cannot but feel, however
obscurely, that behind the phenomena of money costs,
there must lie certain ultimate costs, of which all money •
costs are but the measure. But when we try to explain
what the nature of these real costs may be, we are
plunged in difficulty. Wages, it may indeed seem at
first sight, present no trouble. There is the effort
and the fatigue, the vmpleasantness of himian labor, to
represent real costs. But can we suppose that these
things are measured with any approach to accuracy by
the wages which are paid in actual fact? Is it true,,
even as a broad general rule, that the services which are
most arduous and most disagreeable command the
highest price? And wages are not the only ingredient
of money costs. There are profits: to what real costs
do profits correspond? More difficult still, to what
does rent correspond? These plainly are not questions
upon which he who runs may read. It will be necessary
to devote the next four chapters to their elucidation,;

CHAPTER VI

LAND

§ 1. The Special Characteristics of Land. In the great
process of co-operation by which the wants of man-
kind are supplied, Nature is an indispensable partici-
pant. She renders her assistance in an infinite variety
of ways, of which the properties of the soil which
man cultivates form only one; but the sunshine and
rain which enable the farmer to grow his crops; the
coal and iron ore beneath the surface of the earth, can
be regarded for our present purpose as forming part of
the land with which they are associated. We can
thus concentrate upon land as the representative
of the free gifts of nature, which are of economic
significance. Land in modern commimities is for the
most part privately owned. It can be bought and sold
for a price, and acquired by inheritance. Moreover, it
is a common practice, particularly hi the United
Kingdom, for an owner who does not wish himself to
cultivate or otherwise use the land, not to sell it to the
man who does, but to lease it to him for a term of years
for an annual payment which we term rent. It is there-
fore natural and convenient to envisage the problems,
which we shall consider in this chapter, as problems
concerning the price and rent of land. But, once again,
the laws and principles which we shall state and
illustrate in terms of the current systems of ownership

84 SUPPLY AND DEMAND

and tenure, possess a much deeper significance than
this terminology might suggest.

The fact that land is a free gift of Nature distin-
guishes it in various ways from commodities which
are produced by man. The peculiarities which are most
important from the economic standpoint are (1) that
the supply of land is, broadly speaking, fixed and
unalterable, and (2) that its quality and value vary,
from piece to piece, with a variation which is immense
in its range, but fairly continuous in its gradation.
These are thus two aspects from which the phenomena
of price and rent can be regarded; aspects which it is
usual to call, (1) the scarcity aspect, (2) the differential
aspect.

§ 2. The Scarcity Aspect. The fact that the supply of
land is fixed has the following significance. If the
demand for land increases, the price will tend to rise.
This is also true, for a short period at least, of an
ordinary commodity. But, in the latter case, there
would ensue an increase in supply which would serve to
check the rise in price, and possibly, if production on a
larger scale led to improved methods of production,
bring the price down eventually below its original level.
In the case of land, no such reaction is possible. There
is nothing, therefore, to restrain the price (and the rent)
of land from rising indefinitely, and without limit,
if the demand for it should continue to increase. Con-
versely, if the demand for land falls off, there is nothing
to check the consequent fall in price and rent. In the
case of ordinary commodities, the supply would be
diminished, because most things are either consumed

LAND 85

by being used, or wear out in the course of time, and
a regular annual production is therefore necessary to
sustain their supply at the existing level. But land
remains, whether it is used or not; and its supply is,
broadly speaking, just as incapable of being diminished,
as it is of being increased. Changes in the demand for
land in either direction are thus likely to affect its price
in a much greater degree than that in which the price of
an ordinary commodity will be affected by a correspond-
ing change in its demand.

For most purposes, however, it is of more interest
to compare land with other agents of production,
especially with capital and labor, rather than with
ordinary commodities. Now, as we have already
noted, there is some doubt as to the manner in which
the supply of capital or labor is Hkely to be affected
by alterations in demand price. But the supply of
capital and the supply of labor, even if we suppose
them to be as entirely imresponsive to price changes as
is the supply of land, are at any rate not fixed. Not
only may they vary for many reasons, but they are in
fact likely to vary in direct proportion to the population.
An increase in population implies an increase in the
supply of labor; and it is likely to be accompanied
by an increase in. the supply of capital; in other words,
the supply of these agents will expand, as the demand
for them expands. But the supply of land will remain
what it was. This fact is enormously important in
connection with the broad problem of population, which,
will form the theme of Volume VI.

But it is important also in other connections. It has
been the dominating factor in many absorbing con-

86 SUPPLY AND DEMAND

troversies upon high policy regarding the ownership of
land, or the taxation of land values, upon which we
can touch but lightly here. It has seemed to many
writers a reasonable proposition to lay down, that the
ordinary course of the progress of society, the increase
of population and industry, naust mean, as a broad
general rule, a constant increase in the demand for land.
And, if that be granted, it seems to follow that the
price and rent of land will tend constantly to increase.
John Stuart Mill, accordingly, in the middle of the last
century, asserted that "the ordinary progress of a
society, which increases in wealth, is at all times tending
to augment the incomes of landlords; to give them
both a greater amount and a greater proportion of the
wealth of the community, independently of any trouble
or outlay, incurred by themselves,"^ and upon the
strength of this assertion, he justified the policy
of imposing a special tax upon what we have come
to call the "imearned increment" of land. But how
far does actual experience bear his assertion out?
In Great Britain we have seen in the last haH-centuiy
an undoubted increase in urban rents; but over long
periods at least, there was a marked fall in both the
prices and rents of agricultural land, despite the
fact that the country was "increasing in wealth"
as rapidly as ever before. This was due, of course, in
the main to the increased supplies of wheat and other
foodstuffs coming from the New World: and if, accord-
ingly, we choose to lump together not only our own
urban and agricultural land, but the land of other
countries as well, and to speak vaguely of the demand
1 Principles of Political Economy, by John Stuart Mill.

LAND 87

for land as a whole, it might seem as though we could
argue that Mill's generalization still holds good. But
even this is by no means certaia and in any case such
a generalization is of very little service: what the
illustration sbould rather suggest to us, is the danger
of speaking of land vaguely as a whole, and the impor-
tance of turniag our attention to the variations in value
between different kinds and different pieces.

§ 3. The Differential Aspect. Most ordinary commodi-
ties are not produced on a single, uniform pattern. As a
rule there are many variations of grade and quality,
and consequently of price. But these variations are
usually designed to meet the differences of taste among
the piu-chasers, and we do not expect to find that any
variety of an ordinary commodity will be produced,
which is so poor in quality as to be entirely valueless.
But since it is nature which has produced the land,
without any assistance or guidance from man, there are
many pieces of land which are so unfertile, or are other-
wise so unsuitable for productive purposes, as to be
quite valueless from the economic standpoint. Even
in a densely populated country Uke Great Britain, there
are considerable tracts of land which it is unprofitable
to employ for any economic purpose whatsoever, and
which possess no further value than what the mere
pride of ownership may give them. This fact makes it
possible to apply the conception of the margin to the
case of land with particularly illuminating results.

In the first place, however, it should be observed
that the value of any piece of land does not depend
solely on the intrinsic fertility of the soil. The fact that

88 SUPPLY AND DEMAND

land is an immobile thing makes its situation a factor of
great importance. In the case of urban land, situation
is, of course, the only thing that counts. The value of
a site in Bond Street or the City is entirely unaffected
by its capacity or incapacity for potato-growing
purposes. But even for agricultural land, situation is a
most important matter. A farm, which is so remote
that considerable transport charges must be incurred
to bring its produce to market, will be less sought after,
and less valuable, than one which is much better
situated though somewhat less fertile. In what follows,
therefore, we must speak of the "quality" of a piece
of land in a broad sense to include advantages of
situation, as well as of fertility. Let us now, imagine
the different pieces of land in Great Britain to be
arranged in order of quality, so that we have a long
series, with land of the best quality at one end, and of
the poorest quahty at the other. At the latter end, we
will have such land as is found near the top of Snowden
or Ben Nevis, which it clearly does not pay to cultivate
at all. Somewhere, then, between these two extremes,
we shall come to a point where the land is just, but only
just, worth cultivating, or where, to revert to a form
of words we previously employed, it is a matter of doubt,
whether the land is really worth using for a productive
purpose. Such land we can regard as the "marginal
land"; and since the variety of nature is at once
infinite and fairly minutely graduated we shall probably
find that on one side of this margin there is much land
which is only slightly superior, and on the other, much
which is only sUghtly inferior, to the marginal land
itself. What, then, is likely to be the value and the

LAND 89

rent of this marginal land, this land which is just on the
"margin of cultivation"? Some readers may find the
answer startling. The rent of the marginal land will
be nil, because it will not pay to cultivate it, if any
appreciable rent is charged. A piece of land for which
it is worth a tenant's while to pay an appreciable rent,
will not be the marginal land, because there will be land
just slightly inferior to it which it will also pay to
cultivate if a somewhat lower rent is charged. And so
we can pass to poorer and poorer qualities of land,
with an ever diminishing rent, until at the margin of
cultivation the derived utility of the land is negligible
and the rent vanishes.

This certainly is a somewhat abstract conception;
but it is by no means so remote from reality as may at
first sight appear. The reader may protest that in the
course of an extensive and varied acquaintance with
landowners, he has not yet run across this peculiar
marginal type, who lets his land for no rent at all. But
there, if his experience is really extensive, I think he
is mistaken. It so happens that the ordinary agricul-
tural landowner leases out his land, not by itself, but
together with a variety of other things such as farm
buildings, which it costs him a considerable sum of
money to provide. He will not as a rule be willing to
go to this expense, unless he sees his way to obtain for
the farm an annual payment, which represents at least
a fair return on this capital outlay, as big a return as
he could have got, for instance, by investing the
same amoimt of money in some gilt-edged security.
This annual payment will, it is true, be called rent;
but the significance of this is that what we term rent

90 SUPPLY AND DEMAND

in ordinary life is usually a complex thing, made up of
two essentially distinct elements, viz. the normal return
on the capital goods supplied together with the land,
and what we may call the "net rent," or the "pure
rent" attributable to the land itself. Now will any
reader make so bold as to say that there is no land under
cultivation, in respect of which this net rent is either nil
or negligible? The landowners will not agree with him.
It is not a question, it should be observed, as to whether
the rent obtained represents more than a fair return on
the purchase price paid for the land; that is quite another
matter. The question is whether the rent obtained
exceeds a fair return on the capital sum spent on the
buildings, etc.; with which every farm must be equipped
to let at all. In fact there are not a few farms where
there is no such excess, and where accordingly there
is no "net rent" or " pure rent" which can be attributed
to the land.

The question whether it would be profitable to cul-
tivate any piece of land, turns upon whether the re-
ceipts which would be obtained by selling the produce
would exceed the costs of cultivation : and mider these
costs of cultivation we must include, of course, the
remuneration of the farmer's services. Farmers, like
other people, have to live; and they would not take
on the troublesome job of farming, unless there seemed
a prospect of making a living out of it. The remu-
neration of the farmer takes, of course, the form not
of a salary, but of profits: and these profits vary very
much from year to year, and from place to place, and
from man to man. But they are essentially payment
for work done, and an ordinary profit must be regarded

LAND 91

therefore as part of the necessary costs of fanning.
Thus it will not be worth while to cultivate a piece
of land, and the land will in fact lie iinused, upon
which a careful farmer might obtain a profit in the
ordiuary sense, of no more than $50 or $100 a year.
The marginal land will be land which yields a decent
profit to a decent farmer, as well as a gross rent to the
landowner, sufficient to compensate him for his capital
outlay, but nothing further.

What, then, will be the rent of a fertile and well-
situated farm, about which there is no doubt that it is
well worth cultivating? Part of the gross rent which
the landowner receives must again be regarded as
merely a retm-n for the capital expended in equipping
the farm for use; but in this case, there will be a residue
left over, which constitutes the net rent of the land.
The net rent will measiure the derived utility of the
land to its occupier, and will in general represent
(very roughly, of coiurse, in practice) the differential
advantage of cultivating the land in question rather
than land on the "margin of cultivation. " This differ-
ential advantage may take either, or both, of the forms,
of a larger produce per acre, or a lower cost of produc-
tion and marketing. But, in any case, the extra profit,
which, if no rent were charged, a decent farmer could
obtain by cultivating the farm in question, rather than
a marginal farm, will be roughly equal to the net rent
which his landlord can exact from him, if his landlord
so chooses. The landlord may, of course, not choose
to exact a rent as high as this; and as a matter of fact,
in a country like Great Britain landlords often con-
tent themselves with less. The traditions associated

92 SUPPLY AND DEMAND

with the ownership of agricultural land, and with the
relations between landlord and tenant serve to soften
the edge of economic law, and to subject the rents-
which are actually fixed to the control in no small
measure of the general sense of what is fair or cus-
tomary. In such cases the landlord makes the farmer
a present, for the time being, of part of the economic
rent. On the other hand, as Irish agrarian history
well illustrates, the landlord may sometimes expro-
priate under the name of rent, permanent improvements
which are due to the labors or the expenditure of the
tenant. This is, of course, particularly likely to happen,
whenever it is the custom to leave to the tenant the
obligation of providing the capital equipment of the
farm, which in Great Britain is, for the most part, the
recognized duty of the owner. Again, in the case of
xirban land in the South of England, expropriations
of this kind are an essential and well-imderstood fea-
ture of the leasehold system. The owner grants a
lease for a long period of time, usually ninety-nine
years, for a ground rent, which is notoriously below
the true economic rent of the land, subject to the
condition that the leaseholder must erect upon the
land and keep in good repair certain buildings, which
on expiry of the lease will become the property of the
groimd owner. Here the nominal groimd rent is only
part of the total rent which is really paid; the ultimate
transference of the buildings representing often the
more important part. There is, in fact, a great variety
of systems of land tenure, some of which are highly
complex, the respective merits of which vary greatly,
and which constitute a most important problem for

LAND 93

statesmen and legislators. Considerations of this kind
in no way diminish the importance of the general
analysis of rent, which we are pursuing in the present
chapter. Rather they make it the more important,
because we cannot properly weigh the merits of any
system of land tenure, imtil we have grasped clearly
the principles governing the rent of land in the purest
form. But certainly we must never forget that the rent
we are discussing may differ very greatly from, though
it will vitally influence, the money payments which
are called rent in actual life. It is the pure economic
rent, the rent which represents the full annual pay-
ment which it would be worth paying to obtain the use
of the land alone, which will measure, as we have said,
the difl^erential advantage of the land in question
over land on the margin of cultivation.

A clear grasp of this relation helps us to perceive
that an increase in the prosperity of the commimity may
sometimes influence rents in an imexpected way. It
all depends on the causes which have given rise to
the increased prosperity. An advance, for instance,
in agricultural science will faciHtate a more abundant
supply of foodstuffs; but it will not necessarily in-
crease the aggregate rents of agricultural land. For if
it takes the form, say, of the discovery of some new
artificial manure, it will very hkely facilitate production
on the less fertile soils far more than it will on the more
fertile soils where artificial manures are not so neces-
sary. It will thus tend to diminish the differential
advantages of working on the more fertile farms, and
their rents will accordingly fall, possibly by much more
in the aggregate than any increase in the rents of the

94 SUPPLY AND DEMAND

farms near the margin of cultivation. The point may,
perhaps, be better understood if we pass from agricul-
tural to urban land, and ask what would be the effect
on site values of a great improvement in the facilities
of internal transport. Push the case to an extreme, and
suppose passenger transport to become so cheap and
so quick that there ceases to be any advantage in
living in a town so as to be near your place of work.
Urban landlords would no longer be able to obtain the
high rents they now receive for the sites of houses
in or near a town. For most people would prefer to
move out into the country where sites can be obtained
at little more than an agricultural rent. The country
covers so large an area relatively to the towns that
the supply of rural sites would be still very plentiful as
compared with the demand. Their rents would not,
therefore, rise by very much, although the rents of the
housing sites in towns would fall heavily. Of course,
there are other factors to be taken into account before
we could pronounce upon the effect on aggregate rents.
Central sites for shops might, for instance, fetch a
higher rental than before. The purpose of this discus-
sion is not to generalize but to show the danger of gen-
eralizing about rents in the aggregate, or land as a whole.

§ 4. The Margin of Transference. The last illustration
may serve, however, to remind us of an obvious fact
which we must now take into account. The same
piece of land may be used for a variety of purposes.
It may have been used for growing corn, and later it
may be devoted to the building of houses, or, as at
Slough, to a repair depot for motor vehicles. It need

LAND 95

hardly be said that the land will, as a general rule,
be put to the use in which its value is greatest; or to
speak more strictly, in which the biggest rent, or the
biggest selling price can be obtained. But the notion
of the differential advantages which a piece of land
possesses over the marginal land becomes decidedly
more complicated when we take accoimt of this variety
of uses. Let us turn our attention, for instance, to the
sites used for shop and office purposes, and consider
what we can regard as the marginal site in this connec-
tion. Clearly it will not be the marginal land of which
we spoke above, which it only just paid to cultivate,
and which yielded no rent at all. For this will prob-
ably be agricultural land in an out-of-the-way dis-
trict, where no one would dream of setting up an office
or a shop. Any site upon which a sane man would con-
template setting up a shop will certainly possess value
for other purposes, such as house-building. Hence the
marginal site for shopkeeping purposes will not be like
our margtaal farm, a site which yields no rent.

As regards many pieces of land, there is no doubt
as to the purposes for which they can most profitably
be used. This piece will command a much higher rent
as a shop site than in any other capacity; for that piece
house-building is the obvious employment; for another,
agriculture. But in quite a munber of instances there
is considerable tmcertainty. It is not clear whether
upon this site it will be better to erect a house or a shop,
or if the latter, what kind of a shop. It is not clear
whether it will pay to use that farm land for a building
scheme; and, within the domain of agriculture, which
of course comprises an immense variety of really dif-

96 SUPPLY AND DEMAND

ferent industries, it is often a very moot point indeed
whether a certain field should be left under grass, or
brought under the plow. Cases of this sort are not phan-
toms of the imagination; they emerge on every side as
concrete problems with which some one or other is deal-
ing every day, and it is these cases which constitute the
marginal land for the purposes of a particular occupa-
tion. The marginal sites for shops are the sites for which
it is only just worth while to pay rents sufficient to entice
them away from houses. And the rent for a site in Bond
Street, or elsewhere, which is so much more suitable for
shop purposes that no alternative use would be worth
considering, will exceed the rent paid for one of these
marginal sites by, roughly speaking, the extra advan-
tage it possesses for shop purposes. Or will fall short of
it, it may be well to add, to the extent of its comparative
disadvantage. For there may be many such marginal
sites, some of which will fetch low rents, and others
very high rents indeed; the same site being often of
great potential utility for a large variety of occupa-
tions. Between any two occupations there will thus
usually be a margin of transference, which we must con-
ceive not as a point, but as an irregular line, upon or
near to which there will be many pieces of land, differ-
ing greatly in the rents which they fetch. These varia-
tions of rent will correspond to the differences between
the advantages or derived utilities which the sites
possess for both the occupations in question. The
position of such margins of transference will of course
alter as industrial conditions change, and, when they
alter, the rents of sites which are not near any margin
of transference will be affected also. Thus an increased

LAND 97

demand for the products of any particular industry
will make it profitable for that industry to offer higher
rents, and thus draw land away from other occupa-
tions. This will have the effect of raising, though
possibly to a very slight extent, the rents of sites which
still remain in other uses; for there will be fewer of
them available; and their derived utilities will con-
sequently be increased.

But here, as everywhere, it is upon the margin that
our attention should be focussed, because it is round
about the margin (wherever it is found) that the
changes are taking place which really matter for society.
When Mr. Mallaby-Deeley buys an estate in Covent
Garden from the Duke of Bedford, the transaction
hardly deserves the degree of public interest it excites.
Nothing has happened which is of material consequence
to anyone except the two gentlemen concerned; the
various sites are still used for the various purposes for
which they were used before; nothing has occurred
that really matters. But when houses are pulled down
for the erection of a cinema, or when a field is diverted
from tillage to pastm-e, something has happened which
affects for good or ill the interests of the whole com-
munity. Conversion from tillage to pasture represents,
indeed, a tendency which has been very marked in
Great Britain during the last generation, and has
aroused misgivings in many pubHc-spirited observers.
Possibly for a variety of reasons, these misgivings may
be justified; certainly the problem is well worthy of
attention. But when in this way the issue is raised of
tillage versus pasture, it is essential, if we are to dis-
cuss it rationally, that we should envisage it clearly

98 SUPPLY AND DEMAND

as applying only to a limited portion of agricultural
land, to the portion which lies somewhere near the
margin of transference, as things are now, between
the two forms of agriculture. It might be socially
desirable to bring under the plow a field which the
farmer finds it only slightly more profitable to lease
under grass; but this would be highly improbable
in the case of a field where the balance of argument
to the farmer in favor of pasture is overwhelming.
The position of the margin of transference between
different uses may, in other words, be somewhat out of
place from the social point of view, and it may be
desirable by appeals and propaganda, even conceiv-
ably by the devices of State subsidy and compulsion,
to push it forwards or backwards in greater or less
degree. But it will be necessarily a matter of degree,
and nothing could be more fooli^ than to speak as
though there was, or could be, some ideal method of
cultivation equally applicable to all lands, without
regard to their climatic and other conditions. Needless
to say, none of the agricultural experts who sometimes
deplore the decline of arable farming are guilty of such
foolishness. But the sense of the diversity of nature
which is very vivid to them may sometimes be lacking in
people who live in towns, and a firm grasp of the mar-
ginal notion may serve best to keep the latter from
forgetting it.

§ 5. The Necessity of Bent. Behind all such detailed
applications there hes a more general consideration
which deserves attention. The way in which the land
of a country is used, the way in which it is apportioned

LAND 99

between the countless alternative employments that are
possible, is a most important matter, more important
perhaps than any questions as to the size of the incomes
which particular landowners receive by virtue of their
rights of ownership. How is this apportionment
effected as things are now? The answer is clear: mainly
by the agency of either rent or price. The business
which finds it worth while to offer the highest rent or the
highest price for any piece of land will, as a rule, be
able to command its use. And, with this as the govern-
ing principle, an apportionment is secured between
shops, ofiices, factories, agriculture, between the im-
mense variety of different employments covered by
each of these broad headings; not a rigid unvarying
apportionment, but one which constantly changes as
economic circumstances change, and as the margin of
transference between different occupations moves hither
and thither. This apportionment takes place at present
as the result of the independent decisions and bargains
of many private individuals, who are thinking mainly of
their own interests, and not of those of the community.
But this state of affairs might be altered. The land
might be nationahzed and allocated to its various uses
by the co-ordinated labors of a great State department,
or some other agency of the collective wUl. However
improbable such a change, it is perfectly conceivable.
But what is not conceivable is that any State depart-
ment should handle the job with a success even ap-
proaching that of the present system, unless it con-
tiQued to use, as its main instrument, the criterion of
either rent or price. That a piece of land would yield a
higher rent in one occupation than in any other is not

100 SUPPLY AND DEMAND

conclusive evidence that it is best to devote it to the
former purpose, but it is very good evidence, and it
should be allowed to prevail unless it is demonstrably
outweighed, as it possibly might often be, by considera-
tions of a different kind. That it would not be well for
the community to employ land in the city of London for
corn-growing purposes, however desirable might be a
revival of home agriculture, is so obvious that it
may seem to have no bearing on the present issue.
But it is only an extreme indication of the absurd
and wasteful use of our natural resources, which would
grow up slowly biit surely, if we dispensed with ideas of
rent and price as sordid irrelevancies, ^and allocated
our land on the basis of a balancing of the loftiest
arguments of a vague and sentimental character. If
you are prepared for the distribution of land to become
stereotyped, for each piece to continue indefinitely
in its present use, then indeed you might dispense with
rent, as primitive societies very largely do. That would
mean stagnation and, for an industrial coimtry, decay.
But if changes are ever to be contemplated, a simple
quantitative measure is the only safeguard against utter
chaos. Thus rent, Hke interest, will be found indispen-
sable as a measure under any efficient system of society,
even if it might not always represent the payment of
sums of money to private individuals. And that is why
the principles governing rent possess, as I indicated at
the outset of this chapter, an importance more funda-
mental than our present system of ownership and tenure.

§ 6. The Question of Real Costs. But we must not
forget the preliminary question that started us upon

LAND 101

our analysis of the agents of production. The rent
which a manufacturer or farmer has to pay for his land
he naturally includes iu his cost of production. But
does this money cost "to the iadividual correspond
to, and measure, any real cost to the community as a
whole? Here let us note in the first place that if only
we could disregard the variety of uses to which land is
put, if we could suppose that all industry was agricul-
ture, and that agriculture was a single industry with a
single product, we could argue that rent does not enter
iato marginal costs at all. For we could regard the
Inarginal producer as the one working on a marginal
farm, whereas we have seen there is no pure rent. The
rent which other producers have to pay would thus
represent merely the destination of the surplus profits
which arise wherever actual costs fall short of marginal
costs. This way of lookiag at the matter has proved
attractive to some thinkers, not in the least because of a
desire to palliate the effects of landlordism, but because
it fits in so well with our general sense of rent as a
"surplus," and a surplus as something distinct from a
necessary price. But it is clearly illegitimate in an
economic theory which professes "to describe the
facts." The marginal land for many purposes fetches,
as we have seen, a considerable rent; and this rent is
certainly part of the marginal costs and of the necessary
price of the products of the particular industry. The
answer to our question is, however, not now very diffi-
cult to see. Land, greatly as it differs in many respects
from the other agents of production, resembles them in
the very important respect that, being used for one
purpose, it is not available for other purposes, and that

102 SUPPLY AND DEMAND

the productive powers of the community in other direc-
tions are thereby diminished. This is the real cost to
the community, which attaches to the products of any
industry, in virtue of the land which it occupies;
not any human labors or sacrifices required to produce
the land itself, but the curtailment of the natural
resources available for productive use elsewhere. This
is the real cost of which rent is the money measure,
and generally speaking an accurate measure at the
margin of transference between one occupation and
another. A somewhat fanciful use of the term cost,
this may seem perhaps, one not quite in accordance
with our instinctive sense of what real costs should be.
But possibly the real costs represented by wages and
profits may turn out to be not so very different, and
we had best leave the matter there, until we have
examined the nature of these other costs.

§ 7. Rent and Selling Price. In this chapter we have
spoken mainly of the rent rather than the price of land:
the relation between the two things is fairly obvious
and well imderstood, but it will be well not to close
the chapter without a brief account of it. The price of
any piece of land is affected by all the considerations on
which its rent depends, but it is also affected by another
factor which has no influence whatever upon rent.
This factor is the rate of interest. The higher the rate
of interest, the higher the return which a man could
obtain by buying gilt-edged securities, the lower will
be the price that he will pay for a piece of land which
yields a given rent. We can express the relation more

precisely by the formula Price ==r—, — t^^- -,though

Rate of Interest

LAND 103

we must be careful, in applying this formula in practice
to allow for the possible deviations between the nominal
and the true rent, and similar complications. The
price, it must be observed, is derived in this way from
the rent, not the rent from the price. ^ Rent is thus
logically the simpler, price the more complex thing.
It is well, therefore, to analyze in the first instance the
principles of rent, if we Uve in a country where the
practice of leasing land for annual rent is less common
than it is in Great Britain, even if, for whatever reason,
it is the price of land with which we are concerned in
practice. The problem of price contains two distinct
elements which it is not easy to handle when mixed up
together. For the rate of interest represents in itself
an important branch of economics, which wiU require
a separate chapter to itself.

' In this the rent of land differs fundamentally from that of
other things, such as houses. For the price of a house is largely
influenced by the costs of construction of new houses, and should
correspond closely to them in the long run. The same relation
between rent, price and rate of interest will hold good; but the
rents will be affected by changes in the rate of interest, owing to
the reactions of such changes on the supply of houses.

CHAPTER VII

RISK-BEARING AND ENTERPRISE

§ 1. Profits and Earnings of Management. The profits
of a business, as they are ordinarily reckoned, whether
for the purposes of income tax or of a balance sheet,
comprise several elements which are fundamentally
distinct. The relative importance of these various
elements varies greatly from one type of business to
another. The profits of a private business include, for
instance, the remuneration of the work of management,
which in the case of a Joint Stock Company is mostly
paid for by salaries or directors' fees. It is to their profit
that farmers, small shopkeepers, and the partners of
a private firm look not merely for a return upon their
capital, but for the reward of their own labors. " Earn-
ings of Management," as they are usually termed
(though in truth they often cover other and humbler
forms of labor) are thus frequently one of the ingredi-
ents of profits.

§ 2. The Payment for Risk-hearing. There is another
element of great importance about which our ordinary
ideas are apt to be so vague that it will be well to devote
a chapter to its examination. This is the element of
payment for risk, or rather the reward of risk-bearing.
Risk is inherent in all business, as it is inherent in all
life. The vagaries of nature and the vagaries of man

104

RISK-BEARING AND ENTERPRISE 105

are alike responsible. The fanner may find his harvest
ruined by a drought or by a deluge; the coal or the gold,
for the extraction of which you have perhaps set up
an extensive mining plant, may come to an end which
is imexpectedly abrupt. You may put your money
into roller-skating rinks and find that cinemas have
become the rage with the fickle public; sometimes
"the market" may decline for causes which remaia
obscure but with consequences which are disagreeably
plain. But while risk is always present in some degree,
the degree varies enormously from one industry to
another. Now, it is obvious enough that in an excep-
tionally risky industry, where there is a considerable
possibihty that the capital invested will yield no return
at all, the profits of those concerns which succeed
are Hkely to exceed the rate of iuterest on gilt-edged
securities. But what is likely to be the magnitude of
this excess? Is risk-taking rewarded if there is any such
excess, however small? Or will it suffice that the gains
and losses should average out to a fair rate of interest
over the whole industry? To enable us to think closely
let us suppose for a moment that we can measure
accurately what the chances are.

Suppose, then, that there were a precisely equal
chance of success on the one hand and failure on the
other in any enterprise, failure involving a complete
loss of all the capital invested. Suppose, further,
6 per cent to be at the time a fair return on a perfectly
secure investment. What would be the return which
must be expected from the risky enterprise, in the
event of its succeeding, before it will be undertaken?
The reader may be tempted to answer, li per cent.

106 SUPPLY AND DEMAND

But 12 per cent would not suffice. An equal chance
of 12 per cent or nothing, as compared with a certainty
of 6 per cent, does not mean that the risk in the former
case is paid for to the tune of 6 per cent. It means
that it is not paid for at all. In each case what a
mathematician would call the expedatian is a return
of 6 per cent. The odds are evenly balanced; in the
long run, over a large number of cases, if the law of
averages works as we assume it does, you would get
just as much from the one type of investment as the
other. Now, risky enterprises will not, as a rule, be
undertaken on terms like these; investors and business
men will not take risks with the odds precisely equal;
they must have them, or believe that they have them,
in their favor.

§ 3. Monte Carlo and Insurance. To assert this is not
to ignore the strength of the appeal which the gambling
instinct makes to many, if not to most of us. The
taste for gambling is, indeed, so deep and widespread
that it would be foolish to leave it out of account in this
connection. It is clear enough that at places like Monte
Carlo people are prepared to have the odds immistak-
ably against them, apparently for the sheer pleasure
and exhilaration of taking risks. Moreover, though for
most people play at Monte Carlo represents a mere
holiday indulgence, it would be unsafe to assume that
what appeals to them there wiU not also appeal to them
in their business affairs. But what exactly is the secret
of the charm of Monte Carlo? It is the great attractive
force of a small chance of a large gain, as compared
with the deterrent force of a large chance of a small loss.

RISK-BEARING AND ENTERPRISE 107

People will readily pay $5 for one chance in a hundred
of making no more, perhaps, than $400 or $450. And it
is very likely that this holds good in the world of busi-
ness. If, for example, we were to suppose that the pro-
moters of a new enterprise were confronted with one
chance in fifty of a profit of 50 per cent per annum on
their capital, as against forty-nine chances of a profit of
5 per cent, this might well prove a more attractive pros-
pect than a certain return of 6 per cent, although the
strict expectation of profit would be smaller in the former
case. But the risks of business enterprise are not
often of this type. They conform more usually to
the opposite type of a large chance of a relatively
small gain, balanced by a small chance of serious
loss or entire failure. Now for almost everyone the
possibility of a great loss will coimt as a deterrent
(just as the possibility of a great gain may count as
an attraction) for much more than its strict actuarial
value.

The truth of this proposition is demonstrated by the
existence of institutions more impressive than Monte
Carlo — ^the Insurance Companies, which play so large
a part in the economic life of modem times. Every
year, and upon an ever-growing scale, both private
individuals and business concerns pay sums of money,
which reach in the aggregate a colossal sum, as pre-
miums to insure themselves against loss by Fire,
Shipwreck, Burglary, Death, Death Duties, against
every risk which Insurance Companies wiU cover.
Now Insurance Companies are not, as we say, in
business for their health. They find their business
profitable, and pay good dividends to their shareholders.

108 SUPPLY AND DEMAND

Moreover, they incur a considerable expenditure on
offices, on clerical staff, on agents, and the like. All
these payments must be defrayed out of the premiums
they receive; so that it is plain that the premiums
greatly exceed the expectation of the risks insured.
The odds are heavily in favor of the Insurance Com-
pany — of that the stupidest person can have no shadow
of doubt. Yet we continue to insure, as private indi-
viduals and as business men, and so far from being
ashamed of our proceedings as a weak and nerveless
folly, which somehow we are unable to resist, we blazon
them forth in the strong accents of conscious pride.
We preach insurance to our neighbors as the core of
self-regarding duty, and, if ever we feel a twinge of
uneasiness, it is lest we, too, may have omitted in some
particular to practice what we preach.

The significance of this is unmistakable. Be our
psychology what it may, however deep and irre-
pressible our taste for derring-do, however inadequate
the scope which the dull routine of modem hfe aiBfords
for our adventurous impulses, we are most of us anxious
to avoid the risk of great financial loss. We are very
glad to find someone to take it off our shoulders if we
can; so glad that we are prepared to pay him for the
service, to pay him a sum which covers not only the
actuarial equivalent of the risk, but something sub-
stantial over and above. In this we are entirely ra-
tional. Our conduct is justified by the law of the dimin-
ishing utility of money, which was noted at the end of
Chapter III. It would be plainly foolish, for instance,
to substitute for the certainty of an income of $2500
per annimi an even chance of S5000 or nothing, since

RISK-BEARING AND ENTERPRISE 109

the utility to us of $5000 is^not twice as great as that
of $2500.

The majority of business risks are not of a kind
against which it is possible to insure. Insurance com-
panies confine themselves to risks which are mainly a
matter of what we call objective rather than subjective
chance, i. e. risks in respect of which knowledge of de-
tailed facts peculiar to the individual case is of minor
importance. But such knowledge is of paramount im-
portance in the case of ordinary business risks. If, for
example, a new enterprise is to be undertaken, the spe-
cial knowledge and experience which its promoters
possess is a vital factor in determining their estimate of
the risk involved. An outsider with no special knowl-
edge would necessarily require to estimate the risk far
more highly if we were to form a rational opinion on the
basis of his knowledge. So great, indeed, would be the
risk to him, that we can lay it down as a sound maxim
that people are extremely rash who invest their money
in risky undertakings about which they know very
little. This subjective aspect of business risk has a
significance to which it wiU be necessary to revert.

But, though most business risks are not and cannot
be a matter for premiums and policies, the principle,
which the practice of insurance illustrates, applies none
the less. In the fight of their knowledge and experience,
the promoters of a new undertaking must weigh up
the chances of failure and success, though they will not
do so by the precise methods of an actuary. They will
require that any chances of serious loss should be
balanced by such chances of exceptional gain, as would
raise the expectation of profit weU above the normal

110 SUPPLY AND DEMAND

return on secure investments. The more risky the
project seems the greater, generally speaking, must
be the expedation of profit required to induce people
to undertake it.

If we suppose business men to calculate reasonably,
it foUows that the average profits in any industry over
a long period of years, reckoning in the losses of the
concerns which disappear altogether, are likely to be
higher, the more risky is the industry. Such a result
wiU not, of course, occur in every case. Even when the
calculations are reasonable, they may be entirely falsi-
fied by the event. Moreover, business men may not
calculate reasonably on the information which they
have. But, unless we suppose their judgment to be sub-
ject to a prevailing bias in one direction, i. e. to be un-
duly optimistic as a general rule, we should expect, and
in any case they must expect, profits above the ordinary
in a risky industry.

This conclusion is sufficiently important. Far too
many people, though they adnait it when it is expressly
stated and dismiss it even as a tiresome commonplace,
are apt to neglect it when the occasion for applying
it arises. For example, the great importance to any
industry of good management is generally recognized,
and the consequent desirability of paying adequate
salaries to the managerial staff. The importance
of securing a supply of capital is veiy widely recog-
nized, and the practical necessity of paying a fair rate
of interest is thus, however grudgingly, conceded.
But the "residuary profits," as they are called, which
accrue at present to the owners of a business, are de-
nounced in some quarters in a sweeping fashion,

RISK-BEARING AND ENTERPRISE 111

which seems to ignore altogether the all-pervadiog
element of risk. People speak as though you might
appropriately limit profits in every industry to some
uniform percentage on the capital employed, with-
out making it clear whether you would even be allowed
to make up ia good years for the losses incurred in
bad. The effect of introducing any such crude device
into our present industrial system could only be to
paralyze enterprises of an unusually risky kind, which,
so far from being pushed to an excess at present,
are more probably curtailed unduly from the stand-
point of what is socially desirable. Like the fixing of a
low maximum price for a commodity it would cause the
supply to wither up and disappear.

§4. Risk under Large-scale Organization. While this
is true of the present economic system, the question
is worth considering whether it represents a fundamen-
tal necessity, whether, for instance, tmder our world
socialist commonwealth the factor of risk-bearing need
play so important a part as it does in the actual business
world. This question cannot be answered with a
conclusive simplicity; opposing considerations present
themselves, between which it is not easy to strike a
balance. On the one hand, ia accordance with the law
of averages gains and losses tend to cancel out over a
large series of transactions, when reasonable calculations
have been made. Thus Insurance Companies, while
they take heavy risks off the shoulders of policy-holders,
incur relatively trifling risks themselves; they can
predict the aggregate sums which they will be called
upon to pay within a small margin of error. In the

112 SUPPLY AND DEMAND

same way it might seem that every enlargement of the
scale of business would make for an automatic insurance
and a consequent economy of risk; and thus that if all
businesses were comprised in a single financial unit,
gains and losses would cancel out over so wide a range
that the degree of risk remaining would be almost
negligible.

This might indeed happen, if busiaess risks were
mainly of that objective kind in which the insurance
companies specialize; for then we could assume that the
chances of success or failure would be estimated reason-
Ably. But, in fact, most busiaess risks, not beiag of this
kind, must be estimated by processes of human judg-
ment, which are very faUible. And here we must take
accoxmt of the law of averages in another aspect,
with a different bearing on the argument. When an
industry comprises a large number of separate concerns,
and the decisions accordingly are taken by many men,
acting independently of one another, the errors of
calculation will tend to some extent to cancel one
another out. The imdue optimism of one man will be
balanced by the undue pessimism of another; and, if
there is no prevailing bias in either direction, the errors
of judgment will not affect the results for the industry as
a whole. But where the effective decisions are taken
by very few men, the chances are far greater of a pre-
ponderating balance of error in one direction. The
risks dependent on the factor of hmnan judgment tend
therefore to increase.

This truth can be illustrated by a phenomenon which
is fairly famOiar. It is recognized by intelligent persons
that the risks of speculation in a particular commodity

RISK-BEARING AND ENTERPRISE 113

market or stock market increase more than propor-
tionately to the scale of operations. A man who sets
out as a "buU" upon a small scale can buy without
sending up the price agaiust him in the process, and, if
he decides later that his judgment is mistaken, he can
at any time cut his losses and sell out without much
diflSculty. But a "bull" on a very large scale cannot
complete his purchases except at a price which has been
raised in consequence of his own action, and he cannot
count on being able to "unload" at or near the market
price, should he decide to do so. If, accordingly, he
miscalculates, he cannot save himself from serious loss
as a smaller man might do by a prompt discovery of
his error. His difficulties spring from the fundamental
fact that the effects of his calculations are too great to
be offset by those of the different, and often opposite,
calculations of other men.

Upon the issue whether a growth in the size of the
business unit is likely to diminish risk, the law of
averages thus cuts both ways. The risks arising from
the element of pure chance are more likely, those arising
from miscalculation are less likely, to cancel out.
Upon these grounds alone, it would be unsafe to con-
clude that there would be on balance an economy of risk
under any system of national or world sociahsm.

§ 5. The Efdrepreneur. There remains, however, an as-
pect of the problem which is perhaps more important
than those discussed above. It is probable that risks
would be estimated and undertaken more wisely or
less wisely imder a different system of society or of
industrial organization? Upon this issue, methods of

114 SUPPLY AND DEMAND

precise analysis are out of place, but we may have
something to learn from the emphatic testimony of
tradition. It has become an axiom of business men
that, while Governments can manage with more or
less competence a safe and routine business like a
Postal Service, their success would be unhkely to prove
conspicuous in undertakings where the element of
risk is great. There, it is said, we owe everything in
the past to the enterprise of individual men (for even
joint-stock companies have not been notable as pio-
neers) adventuring their own fortunes in accordance
with their own imfettered judgment. This contention,
however much we may desire to qualify it, has un-
questionably a large measure of truth, and the explana-
tion is not difficult to discover. For the wise taking
of risks in industrial development of an experimental
character, pecuhar conditions and special qualities
are required. First, it is necessary to envisage dis-
tinctly the promising though risky opportunity, and this
caUs not infrequently for imagination of a none too
common order. Then it must be studied with insight
and expert knowledge and weighed by processes which
are as much intuitive as intellectual. The reasons for or
against taking a particular business risk are seldom such
as can adequately be expressed in terms of arithmetic,
or even by clear arguments the soundness of which is
proportioned to their logical cogency. The mysterious
faculty of judgment enters in; and from mental proc-
esses which defy analysis there emerge ultimately con-
viction and the will to act. But it is precisely here
that Government Departments are apt to fail. It is
here that the individual, who need consult no one but

RISK-BEARING AND ENTERPRISE 115

himself, has a pull over any form of organization,
where decisions are reached by the method of debate
and agreement among a heterogeneous committee.
Hence it is that we have come to regard exceptional
risk-taking as the peculiar province of individual
enterprise. It is probable that these deficiencies of
corporate organization are tending to diminish, and it
is an interesting question how far it may be found
possible to eliminate them in the future.

Meanwhile the above considerations have an im-
portant bearing on the rewards which can often be ob-
tained from risky enterprises. The number of individ-
uals who are in a position to envisage a business
opportunity, and to assess with some confidence the
chances of success and failure is very limited. Not only
must they possess special knowledge, ability, imagina-
tion, confidence in their own judgment, and the ca-
pacity to act on it; they must also have at their disposal
considerable financial resources. To combine aU these
advantages represents a imion of circumstances which
is distinctly rare. The fortunate few, who do combine
them, are thus generally able to extract in the form of
profits a high price for their services, a price which
covers not only the strict reward of risk-bearing, and the
necessary remuneration of their own service, but a
handsome payment for the special quahties and ad-
vantages which have been indicated. Profits, moreover,
may vary between one industry and another, not only
in accordance with the real risk which is entailed, but
with the degree to which the supply of special knowl-
edge, etc., is scarce or abundant.

This consideration goes a long way to explain the

116 SUPPLY AND DEMAND

large fortunes which enterprising business men are
often able to amass. It also throws some much-needed
light upon the functions which such men discharge.
They perform to a large extent the work of manage-
ment; they supply capital on what may be a consider-
able scale; but it is the taking of business risk which is
perhaps their most characteristic fimction. It is the
union of these functions which distinguishes them as
an essentially different type from the salaried manager
who has invested his savings in rubber or in oil. In
other languages there is a specific name for the man
who combines all these three functions; in French he
is called an "entrepreneur," in German an "Unter-
nehmer." It is much to be regretted that in English
we have no clear corresponding word. The word
"capitalist" is not uncommonly employed to do duty
in this connection, but this is a source of much con-
fusion. For the wo:;d is also used, and more appro-
priately, to include aU investors, whether or not they
are active business men.

§ 6. Risk-taking and Control. But there is an allied
confusion of more importance. We commonly suppose
it to be a leading feature of our present "capitalist
system" that the control of industry rests in the hands
of those who supply the capital. Nor, as a general
statement, is this untrue. But it conceals the essen-
tial point. Strictly speaking, it is risk-taking with
which control is associated. The mere lending of
money carries with it no title to control. Governments
and municipalities concede no such title to the sub-
scribers to their loans; nor does a company to its de-

RISK-BEARING AND ENTERPRISE 117

benture holders. The shareholders' ultimate control
is based upon the fact that they bear the financial
risks of the concern. Nor -is this a matter of mere
legal form. It is not vmcommon for ordinary shares to
carry with them a greater voting power than the pref-
erence shares of a corresponding value. The principle
which such arrangements endeavor to express is clear:
control should rest with him who bears the risk. It
is with this priaeiple rather than with a mulish in-
sistence on the rights of property, that advocates of
"workers' control" and the like have got to reckon.
It is upon this groimd that (as they may quite con-
ceivably do) they must make good their case.

§ 7. General Analysis of Profits. Let us conclude this
chapter by clearing the ground for the next. Earnings
of management, payments for risk-taking and for the
special knowledge and advantages associated with it,
are ingredients of the gross profits of a busiaess. The
chief element that remaias is that of interest on capital.
Frequently, indeed, it is not the only one. As we saw in
the last chapter, a farmer may not be required by his
landlord to pay the full economic rent for his farm;
and he may therefore make profits above the normal
level, above the ordinary return for his own services,
his own capital expenditure, and the risks to which
he is necessarily exposed. In such a case the farmer is
really the recipient, as we have already suggested, of
part of the economic rent of the land; and an element
of rent accordingly enters into his gross profits. But
profits may include a surplus element which may arise
in a great variety of other ways. A business may

118 SUPPLY AND DEMAND

possess some decided advantage which is not open to
competitors; and it may reap high profits accordingly.
You can, for instance, if you choose, regard the high
money profits, which, as was suggested in Chapter IV,
are likely to accrue in future to the owners of pre-war
factories, as a surplus profit of this kind. But while, as
this illustration indicates, the phenomenon of surplus
profits becomes of very great importance when we
seek to study the distribution of wealth, it need not
detain us here. For the surplus element arises only
in so far as the costs of a business are lower than the
marginal costs; and it is the marginal costs, which,
with good reason, we are now endeavoring to analyze.
The marginal costs must include a normal profit, i.e. a
profit which will cover earnings of management, the
reward of risk and enterprise, interest on capital, but
nothing further. It remains, then, only to consider
this last element of interest.

CHAPTER VIII

CAPITAL

§ 1. A Reference to Marx. Interest is the price paid
simply for the use of capital. But what is capital, and
in what does its use consist? What claim has it to be
regarded as an independent factor of production? Our
very famiUarity with the term, our habit of employing
it with the rich looseness of every-day life is an ob-
stacle to the clearness of thought, which is again
essential. We recognize, most of us, clearly enough
that capital, although we reckon it in terms of money,
consists, Uke income, of real things; factories, machinery,
materials and the like. It is quite obvious that these
things are of use, are, indeed, indispensable for pro-
duction; what more natural than that capital should
command a price? It almost seems as though we might
pass, without further ado, to a detailed discussion of
the forces which determine the amoimt of this price.

But this account does not bring out the essential
point as brief reference to a very famous controversy
will show. Some ingenious writers in the last century,
the most notable of whom was Karl Marx, set out to
prove that, in our modem society, workpeople are
"exploited," robbed of the "whole produce of their
labor," to the full extent of the return which accrues
to capital. The argument was exceedingly complex
in detail; but it boils down to this: The factories and

119

120 SUPPLY AND DEMAND

machinery which are admittedly essential to production
were themselves produced in exactly the same way
as consumable goods. They were produced by labor,
working with the assistance of nature, and, again, if
you choose, of capital in the form of further factories,
machinery, etc. But these further capital goods can
in their turn be regarded as the product of labor,
nature and capital; and so we can proceed until it
seems as though the element of capital must disappear
in the last analysis, as though labor and nature were
the sole ultimate agents of production, and the reward
of capital represented no more than the exercise of the
exploiter's power. In one form or another this argu-
ment still dominates the minds of a large proportion of
the so-called "rebels" against the existing social order.
If we are to meet this argument, if, which is perhaps
more important, we are to understand the true nature
of capital, we cannot rest content with saying that it
consists of factories and machinery, and that these are
essential to the worker. Just as it was well to get
behind the money terms, in which we often think of
capital, to the real goods; so we have now to get behind
the real goods to something else. What this something
else is, the first chapter may have already done some-
thing to reveal.

§ 2. Waiting for Production. Between production
and consumption there is an interval of time. All
productive processes take time to accomplish. The
farmer must plow the soil and sow the seed months
before he can reap the harvest which will reward him
for his efforts. Meanwhile, he must live, and in order

CAPITAL 121

that he may live he must consume. If he employs
laborers he must pay them wages, that they too may
consume and live. For both purposes he requires
purchasing power, which represents of course command
over real things; and if he has not sufficient purchas-
ing power of his own, he must borrow from someone
else who has. In either case it is not enough that the
farmer and his laborers should work; no less essential
is it that someone should wait. The farmer must
wait till he has sold his crops, both for the reward of
his own labor and for the repayment of the wages he
advances in the meantime to his laborers. Or, if he
cannot afford to wait, and borrows in anticipation of
the harvest, then the lender must wait, imtil the farmer,
having sold his crop, is able to repay him. Thus the
period of time involved in all production gives rise to
a demand for waiting, which someone or other must
supply, if the production is to take place. It is this
waiting which is the essential reality underlying the
phenomena of capital and interest. It is really this
which constitutes an independent factor of production,
distiuct from labor and nature, and equally necessary.

§ 3. Waiting for Consumption. But let us carry the
argument a step further. After the farmer has sold
his crops, there are many stages through which they
must pass, at each of which more waiting is required,
before they reach the ultimate consumer. But then the
waiting is at an end.

This, however, is by no means the case with a great
number of commodities. Let us take the case of a
speculative builder. While he is building a house he.

122 SUPPLY AND DEMAND

like the farmer, must wait (or find someone to wait
on his behalf, for his own reward, and for the repayment
of his expenditure on wages and materials. But, after
the house is built, if he lets it to a tenant for an annual
rent, his waiting is far from over. Not until many years
have passed will the rent payments add up to a sum
which equals or exceeds his outlay. He may, of course,
sell the house, and thus bring his waiting to an end.
But then the purchaser must wait, no matter whether
or not he is the occupier. For no one would consider
the use of a house for a day, a month, or a year as an
adequate return for the price it cost to buy. The
occupier-owner pays for the prospect of its use for a long
and perhaps indefinite number of years ahead, and he
must wait to enjoy the benefits for which he pays
now in full. Waiting is as iaherent in the consumption
of durable things as it is in all production.

Now most industries are consumers of durable things
of a very expensive kind. Here we come back to the
factories and machinery which ordinarily spring to our
mind at the mention of the word capital. Not merely ,
does the construction of these things involve waiting;
their consumption involves waiting on a vastly larger
scale. Just as with a house, many years must elapse
before their derived utility can even approximate to
their purchase price. It is mainly to supply the waiting
involved in the consumption of such durable goods,
that a typical joint-stock company issues shares for
public subscription. The waiting required to cover the
period of time, which its own productive process re-
quires, is largely supplied by means of bank overdrafts
or other forms of short-period borrowing. More

CAPITAL 123

strictly, fixed capital represents the waitiog involved in
the consumption of durable things; circulating capital
the waiting involved in current production.

This distinction loses its sharpness when we consider
not the affairs of a particular business, but the industrial
system as a whole. Then the period of time involved
in the consumption of durable instruments falls into
place as part of the time required for the production
of the ultimate consumers' goods. We can even, per-
haps, conceive of an "average period of production" for
industry and commerce as a whole; and this conception
is not without its uses. For it serves to bring out the
fact that the period of consumption, and the period of
production in the narrower sense, are only two aspects
of the same fundamental thing, the interval of time
which elapses between work and the utility, which is
its ultiniate purpose. It serves, moreover, to make clear
that anything which lengthens this interval of time
increases the demand for waiting, or in other words,
the demand for capital; and, conversely, that anything
which shortens this interval diminishes the demand
for capital.

§4. Capiial not a Stock of Consumable Goods. But
the distinction between the two forms of waiting,
though not fundamental, is none the less worth noting.
It enables us to keep our theory in conformity with
fact, to look at the phenomenon of capital the right
way up; and it is easy, if we are not careful, to slip
into the habit of looking at it upside down. People
sometimes speak as though the commodities which
constitute our capital, instead of being mainly, as our

124 SUPPLY AND DEMAND

plain sense tells us that they are, factories, machinery
and other durable instruments, were rather a store or
stock of immediately consumable goods. The argument
takes the following form. It is consumers' goods,
things like food and clothes, which the farmer, the
builder and their workpeople consume while they are
working. To enable them to work, therefore, it is vital
that such things should not in the past have been con-
smned as soon as they were made; part of them must
have been saved, and carried forward for future use.
Furthermore, the longer the time that the work on
which people are now engaged takes to yield its product,
the larger must be this store of consumers' goods. For
these products, when they are completed, will serve
(taking society as a whole) to replace the store which in
the meantime is being used up, so that the longer this
replacement takes, the larger must be the initial store.
Conversely, the larger the store of consumers' goods
available, the more distant is the future for which we
can afford to work. It is thus the store or stock of
consumers' goods which represents our real capital;
for it is the magnitude of this store which determines
how far we can devote our energies to purposes which
are remote in time.

Now this is pure mysticism. Regarded literally,
it is in direct conflict with the facts. The processes
of industry are fairly regular and continuous. At any
moment, large quantities of consumers' goods of almost
every kind are on the point of completion; at the same
moment equally large quantities are consiuned. The
things which we buy were finished, very likely, only
recently; or, if in fact ^hey have lain idle for some

CAPITAL 125

time in stock, there is nothing essential or at all helpful
in that fact. It represents rather a defect — a malad-
justment which should be rectified. Even many kinds
of agricultural produce do not need to be carried for-
ward from one year to another, for they are produced in
many parts of the world, where the seasons come at
different periods of the year. It is conceivable, there-
fore, that we might consume aU non-durable things
the moment they were ready, and the degree to which
we approximate to this ideal is a mark of the efficiency
of our economic system. A large store of consumable
goods is thus not a fundamental necessity of a prosper-
ous society.

What is necessary is plainly the power to produce
these things in large quantities as they are required.
And this power is furnished by the durable instruments
of production, which we thus rightly regard as the true
representatives of modem capital. If it is argued that
this power to produce consumable goods may be re-
garded as being in effect a store of consumable goods, it
must be sternly replied that this is the language of
symboUsm, not of science, and that symbolism is highly
dangerous in this connection. The false conception of
capital as essentially a store of consumers' goods has
led and still leads to many serious fallacies. It was
this that gave rise to the notorious doctrine of the
Wages Fund; the notion that the sum which can at any
time be paid in wages is equal to the quantity of capital,
alias consimiable goods, which happens to exist. To
this day it blocks, with an imdergrowth of obscurantist
controversies, the way to a straightforward account
of the problem of trade cycles.

126 SUPPLY AND DEMAND

§ 5. The Essence of Waiting. But it is with positive
conclusions that we must here concern ourselves.
What is the essence of this waiting, as we have called
it? What are its results from the poiut of view of the
community? The individual, who saves and lends,
waits in the obvious sense that he postpones consump-
tion. He foregoes his right to purchase now a quantity
of consimiers' goods in consideration of the prospect
of purchasing a larger quantity of such things in the
future. From the standpoint of the whole community,
there is a similar postponement of consumption, though
it need not conunence so soon. The store of consum-
able goods is what it is: the quantity of goods in process
of manufacture, which will shortly be coming forward,
is also what it is. For some time, therefore, a sudden
access of saving cannot affect the quantity of goods
available for consumption; and if, in fact, they should
be consumed less rapidly, that will represent an imfor-
tunate defect, not an essential condition of a smoothly
working system. The necessary consequence comes
later. The increased saviug will cause labor, materials,
land, agents of production generally, to be devoted
to distant purposes. Men will be set to work producing
durable goods, largely durable instruments of produc-
tion like ships or railways or factories or plant. If the
increased saving is considerable, the labor, materials,
etc., required for these purposes will be withdrawn
even under our present system, as imder a smoothly
working system they clearly must be, from the pro-
duction of other and more immediately consimiable
things. Hence, some time later, the supplies of con-
sumable things will be diminished, while at a later

CAPITAL 127

period still they will be more than correspondingly
increased as the result of the assistance of the new
durable instruments. That is the essence of saving
from the social standpoint. An early future is sacrificed
to a more remote future. The aggregate consumable
income of the present is unaffected; the aggregate con-
sumable income of the near future is actually dimin-
ished; it is not until at least some years later that the
aggregate consumable income is increased.

§ 6. Individual and Social Saving. This conclusion
is important: but there is an obvious misinterpre-
tation against which it will be well to guard. It is
customary for social morahsts to preach thrift and
saving as a public duty, and to impart to their appeals
a special note of urgency in times like the present,
when, as the result of the havoc of the war, destitution
is widespread over Europe. Now obviously these ad-
visers do not mean to recommend something which
will impoverish the world next year and the year after
and the benefit of which will accrue only in a distant
future: it is the immediate urgency of the world's
needs which is rather the substance of their case. Nor
would it be right to conclude that these wise men are
the victims of a delusion, and advocate a course, the
consequence of which they do not understand. The
explanation of the paradox is simple. The more the
community as a whole saves now, the less in the near
future will be the aggregate consumable income of the
whole community: but not of the remainder of the
community, exclusive of the savers. It is the saver
who must wait, whose consumption must be post-

128 SUPPLY AND DEMAND

poned to perhaps a distant future; but at no time does
his saving result in a smaller income of consumable
goods for other people. The aggregate consumable
income of the near future will be diminished,' but it
may be better distributed, and it may consist of things
of a different kind. For consumers' goods, we must
remember, comprise champagne and motor cars as
well as food and clothes; and, if a rich man saves, it
may be purely articles of luxury, the production of
which will shortly be diminished. Moreover, if his
saving has the effect of transferring purchasing power
to impoverished people, like those in Central Europe,
it will not be devoted to a distant future; it wUl very
likely be devoted to quite immediate ends. In other
words, it may not result in any "creation of capital";
it may not represent any saving on the part of the
community as a whole. A relatively rich man waits,
and a relatively poor man anticipates his income to a
corresponding extent; and it is precisely this that is so
urgently desirable in a time of widespread poverty and
chaos.

This is no matter of hair-splitting, and making
plain things obscure. While it is always better for the
rest of us that an individual, who can afford to save,
should save rather than spend (though it might be
better for us still if we could have his money to spend
ourselves) and while this is the more important the
greater is the poverty which generally prevails; yet,
as a community we cannot save so much, we ought
not to save so much, when we are impoverished as
when we are prosperous. It is vital to appreciate this
truth, because, as we shall see, by no means all the

CAPITAL 129

saving of the world is done by individuals. There are
many forms of " collective saving, " which take place
in actual fact; still more which we. are often urged to
undertake. And it is of practical importance to realize
that the very considerations, which call most urgently
for individual thrift, forbid a great indulgence in such
projects. A time of national poverty is not a time
when it is suitable for the State to embark on large
schemes of capital development: we require our re-
sources for more immediate ends. Faced with such
problems, our practical sense may no doubt suffice to
keep us straight; but it is apt to do so at the expense
of a complete inversion of the real issues. If, for in-
stance, we call for Governmental retrenchment on
what we deem extravagant poUcies of housing and
education, we usually speak as though they represented
the profligacy of a spendthrift as contrasted with
the saving that is indispensable. The truth is rather
that these pohcies represent a saving, an investment for
future purposes, which may conceivably be greater
(this must not be taken as representing my personal
opinion) than the community can properly afford.
This is another instance of what I mean by looking
at the problem of capital the right way up.

§ 7. The Necessity of Interest. It is only now that
we are in a position to appreciate the true functions
of a rate of interest, and the nature of its claims to be
regarded as a "real cost." Interest, it is sometimes
said, is necessary to provide for the future. It is far
more certain that interest is necessary to provide for
the present. It is a matter of legitimate doubt how far

130 SUPPLY AND DEMAND

it is necessary to pay interest to secure a supply of
capital; there is no doubt at all that it is necessary to
charge interest to limit the demand for it. As we saw in
Chapter I, a world socialist conunonwealth would
require to retain a rate of interest, if only as a matter
of bookkeepiag, in order to choose between the various
capital undertakings that were technically possible.
And this is the primary function which the fate of
interest fulfils in our present-day society. It separates
the sheep from the goats. It serves as a screen, by
means of which capital projects are sifted, and through
which only those are allowed to pass which will benefit
the future in a high degree. For this essential purpose
it is hard to imagine how a better instnunent could be
devised.

§ 8. The Supply of Capital. Let us dwell for a moment
on this image of a screen, or sieve. One condition of a
good sieve is that its meshes should all be of the same
size. This condition the rate of interest almost perfectly
fulfils. But it is also important that the meshes should
be of the right size. Whether this is true of the actual
rate of interest is a far more doubtful matter. It is,
indeed, plain that it is not altogether devoid of merit in
this respect. In times of general world poverty, like
those which follow upon a great war, it is desirable, as
has been ai^ued, that more of our productive resources
should be devoted to immediately useful purposes, and
a smaller portion dedicated to a distant future. This
readjustment the rate of interest helps to bring about.
For it rises to a higher level, and there is accordingly
a strong inducement to all manufacturers and traders

CAPITAL 131

to economize their use of capital, and thus to set free
productive resources for more urgent needs. But,
while the meshes of the sieve, as it were, contract in
times when it is desirable that they should contract,
we have no reason for supposing that they will contract
in just the degree that is desired, neither more nor less;
or, indeed, that at any time they approximate to the
right size. We in the twentieth centmy owe much
of the material wealth that we enjoy to the fact that
over the last century men saved as largely as they
did. But our natural gratitude should not restrain
us from doubting whether they were really well advised
to do so. If we ask the question how they managed to
do so, our doubts are deepened. For first place among
the explanations must be assigned to the inequality
in the then distribution of wealth. It was because
many men in England were rich enough to save that our
railways were built, and the resources of new Continents
were opened up. But England, a centiuy or even half a
century ago, was not really a rich community. And if
the national income in those days had been distributed
more evenly among the people, can we doubt that they
would have spent a far larger proportion of it on
immediate needs; can we doubt that they would have
been right to do so? We may rather doubt, in view
of the reactions of poverty on physical and mental
efficiency, on social harmony, even possibly on popula-
tion, whether we to-day would have been really injured
as much as might appear. How, then, can we suppose
that the sum of the amounts which it suits individuals
to save will bear any close relation to the resources
which the community can properly devote to future

132 SUPPLY AND DEMAND

ends? Are we to regard an unjust distribution of wealth
as a mysterious dispensation of Providence for securing
perfect harmony between the future and the present?
The point need not be labored further. There are no
grounds for assuming that we save, as a community,
even roughly what we ought to save. If we wish to
believe we do, we must turn for support from economics
to theology.

It is important to be clear upon this issue in order to
distinguish it from another, with which it sometimes
seems to be confused. This is the question, briefly
outlined in Chapter II, of the effect of changes iu the
rate of interest on the supply of capital. As was there
indicated, there are good reasons for supposing that a
fall in the rate of interest would induce some people
to save more, and conversely. But the balance of prob-
ability is in favor of the conclusion that the net effect
of changes in the rate of interest, though perhaps slight,
is usually of the more ordinary kind. The decisive argu-
ment in this connection is the fact, upon which we have
just touched, that savings are supplied largely by people
who are relatively rich, and who become richer when the
rate of interest rises. For at this point it is necessary to
be careful. It is easy to slide from the above conclu-
sion into an argument of the following kind. A higher
rate of interest leads to more saving; it is thus necessary
to evoke more saving; it is thus required as an incentive
to induce people to incur the sacrifice of waiting; this
sacrifice represents the "real cost" for which interest
is paid.

This terminology of incentive, inducement and
sacrifice is of very dubious validity. A rich man, who

CAPITAL 133

is made richer by a rise in the rate of interest, will
probably save more, but it will be rather because he
has become richer than because he is tempted by
the higher rate: and the less we talk about his sacrifice
the better. Nor is it clear that the attraction of a high
rate of interest is an operative factor on the mind of a
man to whom saving means a real sacrifice of immediate
comfort or enjoyment. Certainly it is only one among
many factors, and seldom an important one. A really
poor man will think not so much of the annual income
which will accrue from his savings, as of the capital
sum upon which he or his family can fall back if a
rainy day should come. And for this purpose he might
save as much as he saves now, even if there were no
interest to be obtained thereby. He might even be
prepared to lend what he had saved, at least to banks
(a deposit with a bank is ia effect a loan), for the mere
advantage of safe custody. The people who save rather
for the sake of the capital sum that can be reahzed than
for that of the annual interest are very numerous, and
probably include many men in receipt of quite consider-
able earned incomes. Moreover, those who consider
mainly the future annual income which their savings
will yield them, are usually more concerned, with its
absolute amount than with the ratio it bears to the
amount they must save in order to acquire it. For this
reason, as has been often recognized, they may save
less when the rate of interest rises, since a smaller
quantity of savings will insure to them the future an-
nual income they desire to obtain. There is no need to
be dogmatic upon any of these points. The psychology
of saving is both complex and obscure. Our conclusion

134 SUPPLY AND DEMAND

must be the negative one that we have insufficient
evidence to warrant the assertion that the particular
rate of interest which happens to prevail is a measure of
the sacrifice involved in saving, even in the case of what
we might regard as the "marginal saving." And, if
we cannot assert this, we must be careful not to assume
it as the basis of other arguments, or as part of a general
analysis of price or exchange value.

It is of some interest to observe that the difficulties
which our world socialist commonwealth would en-
counter if it attempted to dispense with the rate of
interest, would not necessarily include that of obtaioing
a supply of capital. It might, indeed, not find it easy
to determine the proportions in which it should allocate
its productive resources between immediate and distant
ends. Our present system cannot be said to have evolved
satisfactory principles for the solution of this question;
and the socialist commonwealth would have to work
out its own solution. But when it directed that labor
and materials should be devoted to purposes of long-
period utility, there would be an automatic collective
saving, of which no one would be conscious as an
individual sacrifice. Even at the present time, our
capital is not supplied entirely by the savings of iadi-
viduals, but to an extent, which though quite iacalcu-
lable is yet certainly considerable, by involuntary saving
of an essentially similar type to the above.

§ 9. Involuntary Saving. When a mimicipality embarks
on a municipal tramways scheme or any other industrial
enterprise, and pays off by means of a sinking-fund
the capital which it borrows in the first instance, the

1 CAPITAL 135

proceeding amounts, as the defenders of municipal
trading have rightly claimed, to a compulsory and
unconscious saving on the part of the citizens. Their
consumption has been postponed willy-nilly as the
result of the increased rates or the high charges which
they have had to pay; and, when the subscribers to
the original loan have been paid off, the capital of the
community is enhanced to the extent of that loan.
Central governments might similarly increase the supply
of capital by devoting annual revenue to capital pur-
poses; though their actual record, as it happens, is
mainly of a different kind. But what is chiefly a possi-
bility in the case of Govermnents has actually been
carried out on an enormous scale by other institutions.
The development of the joint-stock company system has
introduced a new factor into the problem of the supply
of capital, which is of immense though but dimly
perceived importance. The directors of a company
are technically no more than the servants of the share-
holders. It is the profit of the shareholders that it
is the directors' duty to promote with a single mind,
and the whole capital of the concern, including its
reserves both open and concealed, is the shareholders'
exclusive property. But realities have a way of differ-
ing from forms, and just as in political affairs it is com-
mon to regard the State as a very different thing to the
people who compose it, as a sublime entity with a sepa-
rate existence of its own, so directors are apt to distin-
guish between the company and the shareholders. It is
the company to which they owe allegiance. To pay
away in dividends to shareholders money which they
could employ in extending the business or strengthen-

136 SUPPLY AND DEMAND

ing the position of the company appears to some direct-
ors a necessity hardly less mipleasant than an increased
wages bill, or an Excess Profits Duty. Concessions must
indeed be made to the shareholders' rapacity: but
when something has been done in this direction, dust
can easily be thrown in their not very observant eyes.
Reserves, which within limits are a necessity of sound
finance, can be accumulated beyond those limits, and,
when the further limits of an extreme but just argu-
able conservatism have been passed, there remain the
innumerable devices, known to every resourceful
Board, of hidden reserves, the secret of which is un-
menaced by the meager information of a balance-sheet.
In all this the shareholder, as the directors occasionally
assure themselves, has no real grievance, for he will
gain in the long run, from the appreciation in the capital
value of his shares, all and perhaps more than all that
he foregoes in the meantime in the way of dividends.

In the long run the shareholder is not injured; but
in the meantime he is in effect compelled, without
any consciousness of the proceeding, to save and to
reinvest in the company a portion of the dividends,
which he might otherwise have spent. The reserves
which are accumulated are not allowed to lie idle:/
they are employed either in what are really capital
extensions of the business, or in the purchase of outside
securities, and in either case they represent an increase
in the total supply of capital. The principal which
these proceedings represent is capable of indefinite
extension.

But however possible it might be to secure a supply
of capital without the inducement of a rate of interest.

CAPITAL 137

that rate is indispensable for dealing with the demand.
It is no good saying, "Three per cent seems a fair rate
of interest; let us try and Umit it to that." Given
the amomit of savings which are supplied, the rate of
interest must be allowed to reach whatever figure
is necessary to confine the demand to that amount.
Given the quantity of resources which you have avail-
able for future needs, the meshes of the sieve must be
made as narrow as is necessary to confine the projects
that pass through within those limits. And so, indeed,
it becomes necessary for any particular business to pay
for its capital interest at the market rate, not so much
to secure the saving of it as to secure its allocation from
the common pool.

§ 10. Interest and Distribution. It is unavoidable that
this interest should accrue to whoever it is that sup-
plies the capital. If the capital were supplied, as it
might conceivably be, collectively by the community,
the interest would accrue to the community, and all
would be well. But as things are, the capital is supplied
mainly by the savings of individuals, and largely by
individuals confined to a relatively narrow class. The
profits of Capital have thus a vital influence on the
very serious matter of the distribution of wealth be-
tween social classes. Now, as experience shows, there
is no element in profits which is capable of such radical
change in so short a space of time, as is the rate of
interest. Even before the war it had become hard for
people in Great Britain to realize that 3 per cent Consols
had stood at 114 as late as 1896. "How blest," wrote
two cynical satirists of society in the same period:

138 SUPPLY AND DEMAND

"'How blest the prudent man, the maiden pure,
Whose income is both ample and secure.
Arising from Consohdated Three
Per cent Annuities, paid quarterly." '

It is impossible to read those lines now without a
sense of irony, different from that which they were
intended to convey.

Not only is the rate of interest now double what it
was a generation ago; we have no good reason to suppose
that the present high level will quickly be reduced.
The havoc of the war, of which the widespread poverty
of Europe and the huge debts of Governments are but
two different aspects, makes it almost inevitable that
the rate should rule high in the present decade. This
cannot but exercise a profound influence, of a most
disquieting character on the general level of profits,
and to a lesser extent (for here we must allow for the
effects of high taxation) on the distribution of real wealth
between social classes. Here we are on the threshold
of tremendous issues. We almost feel the earth quake
beneath our feet. We hear the muffled roar of far-
reaching social controversy:

"And 'mid this tumult Kubla heard from far
Ancestral voices prophesying war."

1 Narcissiis, by Samuel Butler and Henry Festing Jones.

CHAPTER IX

LABOR

§ 1. JL Retrospect on iMissez-faire. When, a century
and a half ago, the foundations were being laid in the
Western world of systematic economic theory, the
public attention was much occupied with a subject,
which indeed has not ceased to hold it: that of the
failings of Governments. The general interest in that
topic was shared by the pioneers of economic thought,
of whom, in Great Britain, Adam Smith was the most
notable. It was indeed their practical concern with the
concrete economic issues of the day which very natu-
rally gave the impetus to their scientific quest. It was
hardly less natural that they should have expressed
their opinions on these concrete issues with considerable
emphasis.

Now the keynote of their practical conclusions was
that Governments were doing immense mischief by
meddling with a great many matters, which they would
have done better to leave alone. In this they were in
general agreement with one another; incidentally —
let there be no mistake about it — they were right. But,
as invariably happens in public controversy, their
opinions became crystalUzed in a compact formula, or
ciy, with unduly sweeping implications. This was the
cry of "laissez-faire." Let Governments preserve law
and order; and leave the economic sphere alone. The

139

140 SUPPLY AND DEMAND

economists picked no quarrel with this formula; it
served well enough for workaday purposes to indicate
the lines of pohcy which they rightly thought essential
in their day.

The history of this cry is the history of every cry
which has won a wide acceptance from mankind. It did
good work for perhaps half a century; but then many
crimes were committed in its name. The instrument
which had been forged to clear away a noxious tariff
jungle and the monstrous laws of Settlement, was
turned against Lord Shaftesbury and the Factory Acts.
Not only was inaction recommended to Governments
as the highest wisdom; other instituticins, like trade
imions, were warned off the economic grass. An ideal
of perfect competition became an idol to which much
human flesh and blood were sacrified.

But, what is more to our present purpose, the idea
took root of an intimate association between the laws
of economics and the policy of laissez-faire. People
who opposed some long-overdue measure of State
regulation believed themselves to be justified by the
eternal verities of economic law, and this claim even
the advocates of the measure seldom ventured to
dispute. They took refuge rather in a conception of
economic law as a dangerous monster, whose claws
must be clipped in the interests of the higher good.
This notion that all interference with so-called "free
competition," is a violation (though very hkely fully
justified) of economic laws has sunk deep into our
common thought. So that to this day, whenever we
see at work the hand of a State department, a trust or
a trade union, we are apt to say "Demand and supply

LABOR 141

are here in abeyance," and possibly we add "A good
thing too." Since in the matter of wages, the hand of
the trade union is very generally evident, it is impossible
to discuss the subject-matter of this chapter, until we
have rid our minds of this quite baseless prepossession.
To sweep away this cobweb, I urge the reader to
recall here the general tenor of the analysis of the
preceding chapters. Whether we were dealing with the
price of an ordinary commodity, with joint products,
land or capital, we came across relationships which
seemed altogether more fundamental than oiu- present
industrial system; nor, we may incidentally observe,
were we ever required to suppose that the present
system was one of "perfect competition." These
relationships were almost invariably such that even a
world sociaUst commonwealth would find it necessary
to maintain them. It was not suggested, and most
certainly it must not be thought, that a world socialist
commonwealth, or even a more modest remodeling of
the social order would not effect great changes, possibly
for good, and possibly for ill. The same economic laws
might be made to bear very different fruits, but they
themselves would remain unchanged. What is true in
all these other fields — this should be our predisposi-
tion — is not hkely to be quite untrue in the field of
labor.

§ 2. Ideas and Institutions. Another point is worth
noting here. We are sometimes advised to distinguish
sharply between "What should be" and "What is";
often two very different things. The advice is perti-
nent and useful, particularly in the sphere of sociology.

142 SUPPLY AND DEMAND

But our incorrigible habit of confusing the two things
together is not without justification, or at least excuse.
For, in fact, they gravitate towards one another with a
force which is just as strong as the capacity of man for
understanding and controlling his environment. When
we have a system which is clearly bad, and when we see
our way to make it better, we generally make the change
however tardily. Our sense of "What should be" thus
reacts upon "What is!" Meanwhile, until we can make
the system better, our appreciation of "What is"
affects our sense of "What should be." And the more
so, as we are sensible. For "What should be" is
pre-eminently an affair of relativity. A man may
hold very strongly that equal pay to every individual
is desirable, as he puts it, as an ideal. But this will not
prevent him, in a world in which managers are paid far
more than manual workers, from maintaining hotly
(at any rate, if he is sensible) that to pay the manager of
a particular concern a manual worker's wage would
be monstrously unfair. He would also argue that it
would be highly inexpedient. Equity and expediency
are, in fact, intricately intertwined in our sense of
"What should be"; and our sense of "What should
be" in the particular is governed by our knowledge of
" What is " in the general.

These may seem unnecessary commonplaces. But
they have a vital bearing on the modus operandi of eco-
nomic laws. These laws do not work in vacuo. They
work through the medium of the acts of men. The acts
of men are greatly influenced by their institutions, and
by their ideas of right and wrong. Both institutions and
ideas may serve to smooth rather than obstruct the

LABOR 143

path of economic laws; because the laws may represent
either "what should be" in the general, or "what is" in
the general, and therefore "what should be" in the
particular. This may hold true even of a trade union
or a sense of "fair wages." The business of economic
theory is not to justify a regime of laissez-faire, still less
to show the folly of bringing morals into business. Its
value is rather that it may help us, by improving our
understanding, to shape our institutions, and to adopt
our moral sentiments so as to promote the public wel-
fare. With these general notions in our minds, let us
turn to see how stands the case with Labor.

§ 3. The General Wage Level. The term Labor may be
used in a broad or in a narrow sense. It may be confined
to weekly wage-earners: it may be extended to include
all those who work, as the phrase goes, "with either
hand or brain." It is with all classes of Labor, in the
broadest sense of the term, that we must here concern
ourselves. It will be convenient, however, in the first
instance to ignore the differences between them, and to
consider the forces which determine what we may
regard as the general wage-level.

The general laws of supply and demand hold good.
The wages of labor tend to a level at which the demand
is equal to the supply. For, if the demand exceeds the
supply, if, in other words, labor is scarce, wages tend to
rise, sooner or later in any case, and the more promptly
in proportion as the workpeople are organized. Con-
versely, if the supply exceeds the demand, if in other
words there is general unemployment, wages tend to fall,
and the strongest trade unions cannot resist the ten-

144 SUPPLY AND DEMAND

dency, though they may delay it. Moreover, the higher
the wages that must be paid, the smaller, other things
being equal, is the demand for labor. For, even if
we leave foreign competition out of account, and con-
sider, as it were, labor throughout the world as a whole,
the demand for labor is by no means inelastic. It is
derived along with the demand for the other agents of
production in the manner described in Chapter V.
As was there shown, the greater the supply of the other
agents of production, the greater is likely to be the
demand for labor; but these other agents can be sub-
stituted for labor in a great variety of ways, and aa
increase in wages (unless accompanied by increased
efficiency) will make it profitable for employers to effect
such a substitution, where it was not profitable before.
Thus, higher wages for the same labor efficiency must
stimulate the tendency for capital to act as a substitute
for labor at the expense necessarily (since the aggregate
supply of capital will not be increased thereby) of its
tendency to serve as a complement; and this must mean
a decrease in the volume of employment. Hence the
power of labor to secure a general advance of wages
by concerted or simultaneous trade union action, ap-
phed if you will, not merely to every industry, but to
every coimtiy, is necessarily very limited. Beyond
a certain point, such a policy must result in general
■unemployment; and, if pushed sufficiently far, in un-
employment so extensive that it would continue even
in periods of active trade. Such a policy could neither
be maintained in practice nor would it be a wise policy
from the workers' point of view.

In other words, given on the one hand the conditions

labor! 145

of the demand for labor (i. e. the supply of capital,
natural resources, business ability, risk-bearing and
knowledge of technical processes, etc., which happens
to exist), and given on the other hand the supply of
labor (i. e. both the numbers of workpeople and their
efficiency), the wage-level in the long run is fairly rigidly
determined. The introduction of the phrase "in the
long run" in this connection is apt to provoke com-
ment which may be pertinent, but may be miscon-
ceived. The worker, it is pointed out, is deeply con-
cerned with "the short run " in which he has to live. It
is very true; and it is this that supplies one of the many
justifications of trade unionism. To secure for the
workers advances of Wages, which economic conditions
justify, sooner than would otherwise have been obtained,
is certainly no trivial or contemptible function. But
it is none the less an illusion to suppose that the general
wage-level can be appreciably and permanently raised
by trade union action, except in so far as it increases
the efficiency of the porkers or incidentally stimulates
the efficiency of the employers.

§4. The Supply of Labor in General. The efficiency
of labor may be regarded as affecting either the demand
fftr labor on the one hand or the supply of it on the
other, according as we look at the matter from the
worker's or the employer's standpoint. The employer
is concerned with the labor costs per unit of his output,
the worker is concerned with the wages he receives.
An increase in the efficiency of labor may, and usually
will, mean both a decrease in labor costs to the employer
aad an increase in the earnings of the worker. It is

146 SUPPLY AND DEMAND

thus wholly to the good. But the effects of an increase
m the supply of labor in the sense of a growth in the
numbers of the population are far more dubious. Un-
accompanied by an increase in the demand for labor,
it must result in a diminished remuneration for the in-
dividual worker. To some extent indeed the demand
for labor would ahnost certainly be increased. The
supply of Capital may expand, perhaps proportion-
ately, perhaps more than proportionately to the in-
crease in population. But one factor of production, as
we have seen, is not capable of such expansion. This
is the factor of Land, or Natural Resources. It is the
limitation of this factor which gives rise to what we
have most of us heard of as The Law of Diminishii^
Returns. It is this that is the essence of the problem
of Population, portrayed in somber hues more than a
hundred years ago by Malthus.

This problem will form the subject of the sixth vol-
ume of the present series. In the meantime it may be
suggested that we are easily credulous if we suppose
that the problem has been finally disposed of by the
peculiar progress of an abnormal century. But that
experience has at least destroyed the view that there
need he, or even is in fact in Western coimtries, a rela-
tion between real wages and the numbers of the people so
close and direct that an improved standard of living
must be temporary only, doomed to destroy itself by the
increased population it engenders. One may perhaps
go further and say that it is doubtful even in what di-
rection changes in remuneration will influence the
aggregate supply of labor. When we pass to "what
should bs," it is plain that there is nothing whatever

LABOR 147

to be said for the sort of relation indicated above. The
view once widely held that the principle of population
must inevitably keep the mass of people close to the
verge of the bare means of subsistence was no statement
of a desirable ideal. It was a nightmare; a nightmare
none the less though it may haunt us yet. It is far from
fanciful to suggest that it is because this relation is so
obviously not "what should be" that it may be ceasing
to hold true in fact. But it would be very fanciful
indeed to maintain that as yet "what should be" is
represented by the actual population. Thus, just as
with capital, so with labor, there is no reason to sup-
pose that the aggregate supply is determined by any
fundamental economic law, or corresponds in practice
to what is socially desirable.

§ 5. The Apportionment of Labor among Places. Again,
as with capital, it is when we turn to the apportionment
of labor between different employments that both
economic law and social ideal make their appearance.
It will be well, however, to consider briefly in the first
instance the different question of its apportionment
between places. This was hardly necessary in the case
of capital, because the possibilities of foreign invest-
ment are veiy numerous and easy: the mobility of
capital is thus sufficiently strong (once again it is only
marginal adjustment that is necessary) to establish
over at least a large part of the world something near to
a imif nrm rate of interest. But this is not the case with
labor. People do indeed move from place to place
within a country, and from one country to another, in
response to economic opportunities. That even the

148 SUPPLY AND DEMAND

latter movement may be a considerable thing, the
present population of the United States is a striking
testimony. But obviously the mobility is very in-
complete. Here, then, we have what we might loosely
call an economic law that labor tends to "flow" (as
it is sometimes unhappily phrased) to those places
where it can command the highest reward; we have this
tendency in evidence, but it is far too weak to enable us
to lay down what would deserve more strictly the title
of an economic law, that in the long run the reward of
the same kind of labor is roughly equal in all places.
Perhaps we can say this for many districts in a single
coimtry; but for few countries is this true as between
all their districts. As between countries, it is not re-
motely true.

Here, however, the imperfection of economic law is
balanced by an extreme uncertainty as to the ideal.
Perfect mobility of labor may be economically desirable
in a very narrow sense of the term; but it opens out a
vista of racial, national and cultural problems, into
which it will be better for us not to enter here. We
must take for granted the population of a country,
hke that of the world, as a given fact.

When we do this, the question of its remuneration
is on all fours with the more general question discussed
above. That the remuneration of the labor of a coun-
try is mainly governed by the relations between demand
and supply is an inexorable fact. In view of the intemar
tional mobility of capital, the main distinctive factor in
the demand for the labor of a particular country is the
supply of natural resources, which it knows how to use.
Where the natural resources are great relatively to the

LABOR 149

population, there wages will rule high; where the con-
verse is true, wages will rule low. This result of eco-
nomic analysis is abundantly confirmed by experience.
The relatively high wages in the new world, the low
standard of living in the densely populated East; the
economic history of Ireland are so many object-lessons
of its truth.

§ 6. The Apportionment of Labor among Social Grades.
The question of the apportionment of the labor of a
country among different employments falls under two
heads. Some differences of occupation are associated
particularly in Great Britain with differences of what
we know as class. The movement of labor between
different social grades is clearly a very different thing
from its movement between different occupations in the
same grade. The grades themselves are not easy to
define: not a little ingenuity has been expended on the
attempt, and perhaps the best brief classification that
has been put forward is one which divides labor into the
following four grades: —

(1) Automatic manual labor.

(2) Responsible manual labor.

(3) Automatic brain workers.

(4) Responsible brain workers.

But the matter is one perhaps for the satirist of manners
rather than the economist. It suffices for our purpose
that the distinctions, however vague, are very real.

It is obvious the mobility of labor between the oc-
cupations of a platelayer and a barrister is not very
great. It may seem perhaps to be even smaller than it

150 SUPPLY AND DEMAND

is. For here it is important to bear in mind a general
consideration which is equally applicable to horizontal
movements within any social grade. There may be a
considerable movement of labor between different em-
ployments without any individual worker having to
change his occupation. The personnel of any industry
is constantly changing. At one end, men die, retire, or
are pensioned off; at the other end, young recruits are
taken on. By a diversion of the new recruits from one
emplojonent to another, a radical change can be made
in the occupational census in a comparatively short
space of time. It is in this manner that such move-
ment as takes place is largely effected at the present
time. Within the ranks of the professional classes, a
man does not commonly leave the profession to which
he has beeil trained. But his choice of professioQ is de-
termined by him or his parents not solely on pecuniary
grounds but usually with an anxious scanning of the
general prospects, which include pecuniary advantages
together with many other things. The same thing is
true in no small measure of manual wage-earners. This
general consideration must be borne in mind through-
out the remainder of this chapter.

But even the sons of platelayers do not commonly
practise at the bar. The obstacles in the way are vari-
ous and subtle. Many of them are ideas, inherited
from a bygone epoch, about keeping other people "in
their proper stations," which the whole drift of circum-
stance, and the spirit of the age are rapidly wearing
down. In the new world such obstacles are rare. But
an obstacle of a more tangible and formidable kind
arises from the fact that the liberal professions and

LABOR 151

many business careers require a long and expensive
education and training, which the platelayer is quite
unable to a£ford to give his son.

Now this expense of training is highly relevant not
only to "what is," but to "what should be." It in-
cludes, it should be observed, a negative as well as a
positive element; a long period of waiting before income
begins, as well as the actual outlay on educational and
other charges. When the burden both of the waiting
and the positive costs must be borne either by the in-
dividual or the family, there are few people who would
seriously dispute that this goes to justify, on grounds
of fairness as well as of expediency, a higher level of an-
nual remuneration later on; though many people would
doubtless argue that the amenities and dignities of the
professions should be taken into account on the other
side. But the same consideration makes it a matter of
legitimate doubt whether it would be desirable, even as
an ideal, that the community should provide so com-
pletely the costs of training and of maintenance in the
waiting period, as to make it no longer "fair" that the
individual should be remunerated more highly than
workers in less expensive occupations. For this would
mean that more labor would be absorbed in the former
employments than in principle would be socially desir-
able, for reasons which the argument of the next chap-
ter will make plain. But the most desirable number of
doctors, barristers, teachers, etc., is not a thing which
can be settled on purely economic grounds, and it is
unprofitable to carry further this particular line of
thought. Few people would advocate, as an ultimate
ideal, that the remuneration of the professional grades

152 SUPPLY AND DEMAND

of labor should exceed that of lower grades by more than
the extra expense of training and waiting they involve.
That the excess is usually greater than this at the
present time seems very probable: though it is a matter
on which it is very hard to generalize. But it would
certainly be far greater than it is if the principle of
laissez-faire ruled supreme in these affairs. Fortu-
nately it does not, and has never done so. Even before
the days of free elementary education, the endowment
of education was not unkuown. The ancient public
schools and universities, which have come down to us
from the Middle Ages, are a standing witness to what
in this field a far poorer community thought fit to do.
Their systems of scholarships and exhibitions, no less
than their courts and towers, deserve our notice. For
these were designed to form what we now call "a lad-
der" by which talent could climb from the humblest
origins to the calUngs which then seemed the summit
either of spiritual or of worldly ambition.

This reference to "talent" makes it well to consider
here a factor which necessarily comphcates, though it
does not substantially affect, the whole argument of
the present chapter. There are differences of natural
ability, which no education or training can obliterate,
which it should rather be their business to excite.
These differences are associated to a great extent with
differences of occupation; they should be so associated
far more closely than in fact they are. They are also
associated with differences of remuneration even within
the same occupation; "what should be" here is a ques-
tion which we may excuse ourselves from discussing.
The principle which, however vague, is sufficient for

LABOR 163

our present purpose is that the same natural ability
should command the same reward in all occupations,
subject to differences which should not exceed the dif-
ferences of educational cost and initial waiting they
involve. We cannot assert, as an economic law, that
this is generally true in fact. If ever it becomes true,
it will be due not to "laissez-faire," or "free competi-
tion," but to social arrangements, which express a
sense of what is right.

§ 7. The Apportionment of Labor among Occupations.
When we pass to the apportionment of labor among ■
different occupations in the same social grade, the same
principle as to "what should be" applies in a simpler
form. Equal natural ability should command an equal
reward in all occupations; assuming that differences
in cost of training can be ignored. The reward must,
of course, be interpreted not in terms of money only
but of "real wages," with allowance for the varying
amenities of different tasks. Now it was here that the
extreme advocates of laissez-faire made one of their
cardinal mistakes. They assumed that this ideal would
be best secured by "perfect competition." The em-
ployer would choose the worker who would come for
the lowest wage; the worker would choose the employer
who would pay him the highest wage; and so, by a proc-
ess similar to the higgling of a commodity market, the
desirable uniform wage-level would become established.
But in fact the conditions of the labor market differ
greatly from those of a commodity market. People
are ignorant, do not look ahead, cannot afford to risk
the loss of a job, however wretched, which they happen

154 SUPPLY AND DEMAND

to have got. For reasons such as these, a considerable
departure from laissez-faire is necessary in order to
realize the theoretical results of laissez-faire. To pre-
vent the putting of boys in large numbers into "blind
alley" occupations, you must supplement the foresight
of parents with Juvenile Employment Exchanges and
After-Care Committees. To secure a proper uniformity
of wages within the same occupation, you must have
trade unions. To secure a proper imiformity between
different occupations, you must have again trade unions,
or, failing them. Trade Boards.

That the actions of trade unions are very largely of
this type is a fact insufEciently appreciated by the
middle-class public. The elaborate system of piece-rate
lists which has been evolved in the Lancashire cotton
industry is primarily designed to secure the same wage
for workers of equal efficiency in all mills, irrespective
of the degree to which the machinery is antiquated or
up to date. This result is wholly to the good: not only
does it secure "fairness" for the worker, it stimulates
the employer wonderfully to efficiency. The same re-
sult could never be secured so effectively by the free
play of competition. But this tendency, which is easily
the predominant element in the trade union regula-
tions of the cotton trade, is at least an important ele-
ment in the policy of "The Common Rule" of all trade
unions, though it may often be mixed up with the more
questionable , tendency to eliminate differences of pay
for differences of natural ability, and the unquestionably
bad tendency to discourage output. As between dif-
ferent occupations, the insistence of a trade vmion that
wages must be leveled up towards the wages obtaining

LABOR 155

in similar trades acts again as a far more powerful force
than competition.

But the actions of trade unions are by no means
wholly of this type. They often serve rather to secure
still higher wages for workers who, comparatively
speaking, are already highly paid. It makes httle
difference whether this effect is secured directly by
wage demands, or indirectly by restricting the right
of the entry to the trade. In either case the conse-
quences are the same, and there should be no ambiguity
as to their nature. They are certainly bad for the com-
mimity, certainly bad for the other workers of the
grade, almost certainly bad for the workers of the
grade regarded as a whole. The higher wages must
raise the money costs of production, and result, sooner
or later, in fewer workpeople being employed in that
occupation; larger numbers must accordingly seek
employment elsewhere; and this cannot but depress
the wage rates of less strongly organized trades. Thus
the effect is twofold: a larger proportion of workpeople
will be employed in badly paid occupations; and the
wages there will be lessened.

The power of a strong trade union to secure wage
advances of this type is considerable, but it must not
be exaggerated. Trade unions employ as a matter
of course devices which, in the case of trusts, we regard
as the extremest weapons of monopoly. To say, "If
you buy from anyone except us, you must, not buy at
a lower price than ours," which Messrs. J. & P. Coats
are represented as having done, is analogous to insisting
that if non-unionists are employed, it shall be at the
trade union rate, as every trade union very properly

156 SUPPLY AND DEMAND

insists. To say, "You must buy only from us," the
method of the boycott, as it is called, is analogous to
the very common refusal to work with non-unionists
at all. But in one important respect the tactical posi-
tion of a trade union is weaker than that of an ordinary
combination. It has usually got a buyers' combination
up against it, in the shape of an association of employers.
The latter will be governed in their attitude towards
the workpeople's demands, not only by im mediate
expediency, but also by their own sense of "what should
be"; and they will usually resist demands for wages
greatly in excess of those obtaining in comparable
trades. In this way, the tendency for workers of the
same efEciency to receive the same real wages in all
employments is far stronger than might at first sight
appear.

If we had to rely for this result upon trade unions
alone, it would be highly problematical. For here a
psychological curiosity emerges, which, familiar and
intelligible as it is, is none the less a curiosity. So
far from still higher wages for well-paid workpeople
being regarded in the world of manual labor as detri-
mental to the interests of other workpeople, it has be-
come almost a point of honor to beheve the contrary.
A wage dispute in a particular trade is conceived as
an engagement in a far-flung battle between Capital
and Labor, in which success at any part of the line
will facilitate the victory of the whole army. This
conception contains a measure of truth, as regards
immediate and purely temporary effects; though,
even here, it is made to seem unduly plausible by the
recurrence of trade cycles, which cause wages at any

LABOR 157

time to move in the same direction all along the line.
But, if the foregoing analysis has been appreciated,
the essential falsity of this notion should be evident.
It is an illusion, which should receive no endorsement,
either tacit or express, in any work on economics.
The general wage level of a country cannot be regarded
(except temporarily, and within narrow limits) as a
function of the efficiency of labor organization; it
depends on the far deeper economic facts set out in
§ 3 above.

Let us now try to summarize the conclusions of this
section. There is a tendency towards a uniformity
of real wages for workers of the same grade and of the
same efficiency. This tendency is not due to competi-
tion alone. It is helped by many acts of a collective
kind, arising from a sense of "what should be": it is
obstructed by other acts of a Uke kind, where the sense
of "what should be" is based on imperfect under-
standing. The more people act in accordance with
"what should be," and the better their understanding,
the more will this tendency approximate to an accurate
economic law.

§ 8. Wam^s Wages. The wages of women represent
a problem of great public interest, upon which the
principles laid down in this chapter have a most impor-
tant bearing, and which in its turn serves to illustrate
these principles further. It has been suggested that
male and female labor can be regarded as a strong case
of Joint Supply, and the suggestion is not merely face-
tious. The essential point, that the proportions of
available male and female labor are fairly constant (not

158 SUPPLY AND DEMAND

that they may not alter with time and circumstances,
but that they are essentially independent of the condi-
tions of demand) holds true not only of a country as a
whole, but hardly less of a particular district. If men
and women are to be regarded as separate grades, they
are grades between which immobility is complete.
Now men and women differ in many ways which affect
both the demand for and the supply of their services.
On the one hand, far fewer women wish to enter busi-
ness employments of any kind, as women have plenty of
work that must be done at home. On the other hand,
though women can do many kinds of work as well as
or better than men, it so happens that for much the
greater number of services, which are in large demand
in the business world, men are the more efficient.
Incidentally, it happens that many occupations which
women might do as well as men are closed to them by
exclusive regulations. The resultant of these forces
is that men and women are for the most part employed
in different occupations, and the scale of pa3Tnent
in women's occupations is far lower than that in men's.
Of this last fact singularly small complaint is made.

It is otherwise, however, when we come to occupa-
tions where men are either wholly or partially employed,
where women are at least approximately as efficient
as men, and where the barriers to their entry are at
least formally removed. There a ferocious controversy
rages over what is known as the principle of "equal
pay for equal work." It is easy to understand why
the male trade unionists in, let us say, the engineering
trades, should support this claim. It is also, indeed,
ivMUgihle why the enthusiasts for Women's Rights

LABOR 159

should urge it; but it is much more doubtful whether
they are wise. Possibly they are wise enough in their
generation, since it might not serve them on this matter
to get across the men. But it is clearly not prudential
considerations of this kind by which they are mainly
actuated. They make the demand, with extreme
intensity of feeling, as a demand for fundamental
justice. They are also very obviously inspired with the
belief (similar to the illusion which is a point of honor
with the male trade unionist) that high wages for
women in well-paid occupations will help to raise the
wages of sweated women workers in other trades.

Now, here again, any lack of candor would be in-
excusable. The effect of this policy on the wages in
women's trades is certainly to reduce them. The pol-
icy serves, as powerfully as any trade union custom,
to restrict the entry of women into the men's employ-
ments, and often spells virtual exclusion. For the
"equal efficiency" may be approximate only, and there
may be advantages in male labor from the employer's
standpoint which are none the less important, because
they are not easy to define. Moreover, from the em-
ployer's standpoint, the efficacy of female labor will
be largely a matter for experiment, and "equal pay"
will give him no inducement to experiment at all.
The diminished number of women in these occupations
(as compared with what might have been) increases
the nimiber who must fall back on the purely women's
trades; and it must serve to reduce the wages there,
where organization is by no means strong. I am far
from asserting that this consideration is conclusive
against the principle of "equal pay for equal work"

160 SUPPLY AND DEMAND

(though I think it conclusive against a rigid interpreta-
tion of it) ; for other matters, such as the standpoint of
the male trade unionist must be taken into account.
But the reactions on the wages in women's trades per-
mit of no ambiguity.

In occupations of another type, the issue takes a
somewhat different form. In the teaching profession,
"equal pay" would not exclude the women; it would
be far more likely to exclude the men. For, though the
advocates of the principle would declare that their
intention is that the salaries of women should be leveled
up to those of men, it is more probable that the ultimate
outcome would be a leveling down. Educational
authorities have the ratepayer and the taxpayer to
consider; and, apart from this, they have their own
interpretation of "what should be." To pay a woman
less than a man for the same work may seem glaringly
unfair; but it is not very clear why a woman, who is
an elementary school teacher, should be paid much
more than, say, a hospital nurse, merely because in the
former case a number of men happen also to be em-
ployed. In fact, there is a clashiug of equities in this
connection; and there is little doubt which of them
the educational authorities would prefer. A leveling
down of the men's salaries would make it all but im-
possible to attract men of the desired tj^e into the
profession, and would thus lead to the virtual extinction
of the male elementary school teacher. This might
seem in a narrow sense to be economically desirable.
Why should not men take their services to the tasks
for which they can command a higher reward, and which
women cannot do as well? But whether this would

LABOR 161

be desirable in the true interests of education is a far
more doubtful matter. And this is the real problem
of "equal pay for equal work" for male and female
school teachers. The reader will notice that I have
refrained from alluding to the controversy as to whether
men should receive more on the grounds that they have
wives and families to maintain. That, although a most
absorbing issue, is not the real issue in practice at the
present time. The real issue is a clashing between a
sense of "what should be" on obvious general grounds
and a sense of "what should be " in the particular, de-
rived from the very patent and general "what is" that
men receive as a rule far higher pay than women.

CHAPTER X

THE REAL COSTS OF PRODUCTION

§ 1. Comparative Costs. Beneath the great diversity
of the considerations which are applicable to the dif-
ferent agents of production, certain general conclu-
sions emerge from the analysis of the last four chapters.
In no case did we find that the aggregate supply of the
agent was determined by clear and certain economic
laws, possessing any fundamental significance. The
supply of natural resources is a fixed thing, quite in-
dependent of the efforts or the desires of man. How-
ever the supply of capital and the supply of labor
may react under present conditions towards economic
stimuU, these reactions possess no quafity of inevita-
bility and bear no clear relation to "what should be."
The supply of risk-bearing responds perhaps more
decidedly to the prospects of increased reward; but
it is so intimately associated with special knowledge
and the qualities of business enterprise, as to leave
some uncertainty attaching even to this conclusion.
When, on the other hand, we turn to the apportion-
ment of these factors among different uses, we find
relations which are both clear and fundamental. Laws
emerge which state at once not only "what is" or at
least "what tends to be," but also "what should be";
and it is the fact that they taste "what should be"
that gives them their fundamental character.

162

THE REAL COSTS OF PRODUCTION 163

These conclusions enable us to give a general answer
to the question which was raised at the end of Chap-
ter V: What are the ultimate real costs to which the
money cost of production correspond? The attempt
has often been made to relate money costs to such
things as the effort of working and the sacrifice of wait-
ing. The existence of such costs is beyond dispute.
Much saving does mean a sacrifice of immediate enjoy-
ment to the man who saves. Most labor is irksome and
disagreeable in itself, and involves strain and wear and
tear; while all labor means a deprivation of the utility
of leisure. Workpeople, moreover, do not grow on
gooseberry bushes, but must be fed and clothed from
the cradle; and their rearing and maintenance repre-
sents a real cost which someone must incur.

But the existence (or the importance) of such costs
is one thing, their relation to money costs is another.
In Chapter VIII we saw how difficult it was to estabhsh
any clear relation between the rate of interest and the
sacrifice of saving. The costs of labor present similar
difficulties. The relative irksomeness of two occupa-
tions may affect the relative wages which will rule in the
two cases; so, certainly, will the differences in the cost
of education and training which they require. But
these are matters which concern the apportionment
of labor between different employments. There is
no good reason to suppose that the general wage-level
would be reduced, merely because work as a whole
became less irksome, or involved a smaller physical or
mental strain. The supply of people is not determined
by the same kind of influences as is the supply of a
commodity. Parents do not produce children for tfie

164 SUPPLY AND DEMAND

sake of the wages which the children will receive when
they go out to work; or, if this happens, we rightly
regard it as a horrible anomaly. In so far as parents
are affected by economic conditions it is by their own
economic conditions; the question is rather one of
how many children they can afford to have, than of a
balancing of the cost to them against the incomes
which their children may subsequently acquire. But
other considerations enter in; and, in fact, it is doubtful
how the aggregate supply of labor will react to changes
in prosperity. Finally, the supply of land involves
neither effort nor sacrifice; and, among our money
costs, we have to account for the item of the rent of land.
To dispose of this difficulty by arguing that rent does
not enter into marginal costs (in any sense which is not
equally true of wages and profits) is to lose contact
with reality. Thus the attempt to explain money
costs in terms of the costs of produciag the ultimate
agents of production leads us iato a quagmire of unreal-
ity and dubious hypothesis. For a systematic theory,
which will rest on firm foundations, we must interpret
money costs in very different terms.

The real costs which the price of a commodity meas-
ures are not absolute, but comparative. Marginal
money costs reduce themselves in the last analysis
to the payments which must be made to sedKe the use
of the requisite agents of productions. These payments
tend to equal the payments which the same agents
could have commanded in alternative employments.
The payments which they could have commanded in
alternative employments, tend in their turn to equal
tffe derived marginal utilities of their services in those

THE REAL COSTS OF PRODUCTION 165

employments. It is thus the loss of Utility which
arises from the fact that these agents of production
are not available for alternative employments that is
measured by the money costs of a commodity at the
margin of production.

This conception of ultimate costs encounters an
instinctive repugnance, arising from a mistaken sense
of logical symmetry, which it will be well to examine.
Cost, it is objected, so interpreted loses its character
as an independent entity. It is merely something de-
rived from utility. Now in the earlier chapters of
this volume, we found reason to be impressed with
the general symmetry which pervades the relations
of demand and supply. Moreover, when we considered
the case of ordinary conunodities we found that at
the back of demand and giving rise to it was utility;
at the back of supply, and limiting it, was cost. The
general syBometry between demand and supply thus
seemed almost to imply a fundamental symmetry
between utility and cost. If, then, cost in the last
analysis is derived from utility, does not this make
nonsense of the symmetry between demand and supply,
or, if we cling to this last symmetry as a demonstrable
truth, must we not refuse to admit that cost can be
derived from utility?

This is one of those false dilemmas which supply the
wiseacres of the world with a plausible case for dis-
trusting the logical faculty. If we have good reason for
believing that both of two apparently inconsistent
things are true, the explanation is seldom that one of
them is really false; it is more usually that they are
not really inconsistent. So it is here. The symmetry

166 SUPPLY AND DEMAND

between demand and supply is very great, and we
should always look to see if it holds good, but it is by no
means perfect, and it is in the last analysis that it most
notably fails. It is most important to distinguish
clearly between the utility and the cost of a com-
modity as two separate and independent things. In
Chapter V, it will be remembered, we did not permit
ourselves to derive the costs of producing cotton lint
from the utility of cotton-seed. The refusal to do so was
essential to clear thought; it led to some very useful
practical corollaries. But to derive the cost of a com-
modity from the utihty of something which is produced
with it, as part of the same productive process; and to
derive the cost from the utilities which the agents,
which help to produce it, possess for other purposes, are
two entirely different things. In works on International
Trade, the reader will discover that the comparative
nature of real costs is so unmistakable that a Doctrine
of Comparative Costs is expounded with much formal-
ity at the outset. This doctrine is apt to prove some-
what puzzling, when we have to deal with it as an appar-
ent exception to the general tenor of economic theory.
Its difficulties disappear when we realize clearly that
the real cost of anything is the curtailment of the supply
of other useful things, which the production of that
particular thing entails.

§ 2. The Allocation of Resources. However strange the
above conception may seem, there should be no doubt
that this cost is very "real." Here the irregularities and
maladjustments of the economic world, the recurrence
of trade depressions and the like, do much to obscure

THE REAL COSTS OF PRODUCTION 167

a clear vision of the essential realities. At a time when
there is much unemployment, and much machinery
standing idle, it is so clear to common sense that we
could produce more of some particular thing without
diminishing the supply of other things, that any ap-
parent statement to the contrary may perhaps seem
the height of academic pedantry. But let me ask the
reader to consider with an open mind a familiar parallel.
During the recent war there was inevitably much waste
and muddle in the utiUzation of the military resources
of the Allies. Some regiments would be kept inactive
for long periods, not for purposes of rest or training,
but owiag to some defect of organization. In the
manufacture of munitions, an insufficient appreciation
of the principles of joint demand led to the piling up of
excessive stores of certain materials, which were useless
until commensurate supphes of the complementary
factors could be obtained. It is unnecessary to multiply
examples. The waste of both man-power and material
was immense. But the allocation of these resources
between, for instance, the various theaters of war was
none the less a very real problem, which gave rise to
much engrossing controversy. It was an axiom that
the more resources you employed in Mesopotamia or in
Palestine, the less resources remained available for
France. No one thought of maiataining that, as long
as there was any waste of these resources, so long as
there remained any men to be "combed out" of un-
essential industries, you could pour troops and muni-
tions into Salonika without stopping to consider the
needs of other theaters of war. Such a notion would
have been clearly imbecile, for the sufficient reason

168 SUPPLY AND DEMAND

that the sending of armies to Salonika would do nothing
in itself to secure (however much it might incidentally
stimulate) the more efficient use of the resources which
remained^

Now this is precisely analogous to the problem of
the allocation of our resomrces for the purpose of peace.
Notwithstanding all the wastes and maladjustments
of the economic system, the use of resources to produce
one commodity does in general curtail the production
of others. The mere launching of a new business enter-
prise does no more than the sending of an army to
Salonika, to eliminate waste in the remainder of the
economic organism. Unemployment, broadly speaking,
is a function not of the magnitude of the normal demand
for labor (which affects rather the wage-level), but of
fluctuations in the demand for labor; fluctuations
from one day to another as at the docks, from one
season to another as in the building trades, above all
from one period of years to another as in the cycles of
general trade boom and depression. Nothing will
diminish unemployment which does not serve to
diminish these fluctuations. A new business will not,
as a rule, have any such effect. If it is launched dur-
ing a trade depression (a most unusual proceeding),
it may temporarily absorb imemployed labor and idle
materials. But when the next boom comes, it wiK
be using, though presumably to greater advantage,
labor and materials which, but for it, would have
been employed for other piu-poses. Meanwhile the
causes making for unemplojmient will be unaffected.
Miscalculations will still be made, the building trades
will still become slack in the winter, the casual methods

THE REAL COSTS OF PRODUCTION 169

of engaging dock laborers will still continue, trade cycles
will still recur, while beneath them, and concealed by
them, some industries will expand and others will decay.
Thus, like the armies at Salonika, thei new business
would in effect divert resources from elsewhere.

This truth needs to be finnly grasped in mind. It
is this that makes it in general unsound policy to sub-
sidize industries, either directly or indirectly, by means
of a protective tariff. It is this, indeed, that supplies
the answer to half the economic fallacies that are al-
ways current.

The allocation of resources so as to jdeld the maxi-
mum effect was rightly recognized as one of the most
vital and difficult of our war-time problems. To cope
with it, the Allied peoples devised one instrument after
another, and finally evolved the Supreme Allied Coun-
cil. The analogous problem in the economic world of
peace time is no less important and far more difficult;
but there is nothing to correspond to the Supreme Al-
lied Council. There we rely upon a co-operation which,
as was stressed in Chapter I, is unco-ordinated. That
co-operation has been evolved by the mutual com-
petition of innumerable business concerns, controlled by
men largely animated by the motive of pecuniary profit.
But it has not been evolved wholly by such means:
and how far that competition or that motive of profit
is essential to its efficiency are questions with which
this volume has not been in any way concerned. The
economic laws, the relations between utility, and price
and cost, with which it has been occupied, are an en-
tirely different matter; and these are essential to the
efficiency of any system of society. For if the marginal

170 SUPPLY AND DEMAND

utility of a commodity is equal to its marginal cost, and
if this marginal cost is composed of payments to the
various agents of production at least as great as they
could have obtained if they had been used otherwise,
this amounts to saying that the agents of productioQ
are so utilized as to yield the maximum utility; and
this is the same thing as sayiag that they are so utilized
as to produce the maximum wealth.

§ 3. Utility and Wealth. Upon this last point it is
important to be quite clear. An increase m wealth
seems a solid, tangible reality; something, which,
however much we may scorn, it in our more precious
moods, we recognize, for a rather poor cormnunity,
to be an important object of endeavor. But an in-
crease in utility seems a vague, impalpable notion,
hardly deserving the same practical concern. None the
less the two things are identical. We greatly deceive
ourselves if we suppose wealth to be an objective reality.
It is true that, when we get behind the money ia which
it is measured, we come upon commodities, like food
and clothes and houses and factories, which seem
comfortably solid and objective things; but we also
come upon many services, like those of gardeners and
doctors and hospital nurses, which we are bound to
reckon as part of our wealth, although they are not
embodied ia any tangible commodities. Moreover,
although material commodities are objective realities
in themselves, and in many of their properties, they are
not objective realities ia their property as wealth. A
pair of boots is an objective fact; so is the number of
pairs ia existence at any time, so is their size, their

THE REAL COSTS OF PRODUCTION 171

weight, the quantity of leather or of paper which they
happen to contain. But the wealth which those boots
represent is not an objective fact. It depends upon the
opinion which men and women entertain as to their
utility; and these opinions take us into the subjec-
tive regions of human psychology. Let us suppose,
for instance, that we calculated, on the basis of present
prices, that the boots in existence at the present time
represented Trtnr P^^ ^^ o*^ total wealth. Suppose,
then, that a miracle were to happen; that the skies
opened and rained boots upon us, of every size and
shape and pattern, until we had 1000 times as many
boots as we had before. Could we say that our total
real wealth had been doubled? Clearly we could
not. To obtain boots for nothing, and to wear a new
pair every week, would make us somewhat better off,
but not twice as well off as we were previously. In
other words, the real wealth of a thousand times as
many boots as we have now, is not a thousand times as
great as the wealth of the present number of boots. We
are, indeed, practically restating the Law of Diminish-
ing Utility; and this perhaps is enough to show that
wealth is fundamentally the same thing as utility.

Another point, however, is worth noting. Oiu- real
wealth would be somewhat increased in the case sup-
posed; but if we were to turn to the money measure
of wealth, the opposite result would be far more likely.
For the price of boots would most likely fall to nothing,
and the total value of boots, in the commercial sense,
would accordingly be nothing also. This shows that
money values may be a most imperfect measure of
aggregate wealth; for what money values represent is

172 SUPPLY AND DEMAND

the product of the quantity of the commodity and its
marginal utility, while aggregate wealth is total utility,
which is a very different thing. This, it may be ob-
served, makes all attempts to compare the wealth of dif-
ferent countries or different times, and no less to con-
struct Index Numbers of Prices, imperfect of necessity,
and arbitrary in their foundations.

§ 4. Criteria of Policy. The point has now been reached
at which we must take into account the very important
fact which was mentioned at the close of Chapter III.
The maximum utility which the laws of supply and
demand tend to bring about is a maximum total utility
indeed, but one still measured in terms of money. An
unequal distribution of wealth destroys any necessary
correspondence between that and the maximum real
utility. This consideration, however, does not affect
the general validity of the conclusion that the laws of
supply and demand represent what is socially desirable
now or under any system. For what is at fault here is
the distribution of wealth; and it is that which should
be changed, in so far as it is possible to do so. Now it is
important to realize that whenever it is possible to
supply a commodity to poor people below cost price,
it is possible to alter the distribution of wealth, for that
in effect is what is done. Purchasing power, which may
be taken from richer people by taxation, or which may
be obtained from "collective" profits on other trading,
is in effect transferred to the poor people in question,
though the transference is coupled with the condition
that the purchasing power must be expended in a
particular way. It is in general desirable that the

THE REAL COSTS OF PRODUCTION 173

transference should be made without this condition
being attached. To this general statement, exceptions
indeed exist so numerous and important as possibly to
justify a great extension of social expenditure of this
type. Education should certainly be provided free of
charge,- there are strong arguments for subsidizing
housing; the provision of milk to expectant mothers,
the feeding of school children, such instances can be
multiplied into a very extensive list. But it is impor-
tant to observe that in each ease the justification of the
policy rests in the presumption that the service supplied
is one which it is particularly important that the bene-
ficiaries should have, as compared with the other things
upon which they might have preferred to expend the
equivalent purchasing power, had it been transferred
to them without conditions. Where there is no such
presumption, as surely there is none in the case of the
great bulk of commodities, the relation between price
and marginal cost should be rigidly maintained; it
is the distribution of purchasing power which we should
rather seek to alter. How far is it possible to alter that?
I suppose that it is iuevitable that many readers will
have concluded that the preceding chapters must be
taken to mean that the distribution of wealth is not
susceptible of any appreciable change. I would remind
those readers of an important distinction upon which
impatient people have sometimes based a complaint
against economists. The economist, it is said, analyses
with great pomp and ceremony the laws governing the
distribution of wealth among the agents of production,
but says practically nothiog about the distribution
between individuals and classes, which is the only thing

174 SUPPLY AND DEMAND

of any real interest to practical people. Now the econ-
omist concentrates on the agents of production for
the very good reason that it is only with respect to them
that any clear and certain laws as to distribution can
be laid down. Into the distribution between indi-
viduals and classes there enter other and variable
factors, governed by no fundamental economic law;
and here, the conclusion should at once suggest itself,
is the field for action designed to alter the distribution
of wealth. What is possible or desirable in this field,
it is again not the purpose of this volume to discuss.
It is an obvious, even if not a very helpful conclusioa
that an increase in the habit of saving among weekly
wage-earners might, without appreciably affecting the
distribution between Capital and Labor, greatly mod-
ify the resulting distribution between social classes.
But questions as to how far it might be possible or
justifiable to achieve a similar result by the use of the
weapon of taxation, by changes in inheritance laws, or
by the public ownership of industry take us into a far
more uncertain and controversial sphere. The diffi-
culties and objections which present themselves are
familiar and formidable; but they are of quite a dif-
ferent order from the economic laws which we have
been examining. The laws themselves do not entitle us
to make any dogmatic pronouncement upon these large
issues of social policy.

But this is not to deprive these laws of practical
importance. They represent essential criteria of sound
policy in the sphere of social reorganization no less than
in ordinary business. In our days a curious obsession
has led many people to disparage these criteria, as

THE REAL COSTS OF PRODUCTION 175

though they were the sordid prejudices of a stupid
tradesman. Because it has been found a matter of
obvious practical convenience to maintain the roads
out of taxation or of rates, and to dispense with charges
for their use, it is suggested that the same principle
should be applied to the railways. Or, more commonly,
because it has been found convenient to make the same
charge for the carrying of letters between Land's End
and John o' Groats as between Hampstead and High-
gate, it is suggested that this principle should be applied
to railway rates and fares. It may be well, therefore, to
point out that the justification of uniform postal charges
rests upon the facts: (1) that the costs of collection,
sorting, etc., are so large a part of the costs of carry-
ing a letter, that the real cost between John o' Groats
and Land's End does not differ from that between
Hampstead and Highgate by as much as might at
first sight appear, (2) that the charges in any case are
very small; so that (3) the avoidance of the small de-
gree of taxes and bounties which the present system
implies is not worth the book-keeping expenses which
differential charges would involve. It should be ob-
vious that these considerations apply to the railways
with a greatly diminished force. They might possibly
justify what is known as the "zone" system of charges,
i. e. uniform rates within certain narrow areas. But the
notion of uniform rates throughout Great Britain
conjures up a vision of trains taking coal from South
Wales to Scotland, and others taking coal from Scot-
land to South Wales, in accordance with the slightest
preferences of the consumers, and without regard to the
extra real cost involved, on a scale to which the "wastes

176 SUPPLY AND DEMAND

of competition" afford no parallel. It would in fact
achieve the essential folly of "sending coals to New-
castle." These considerations, however, are not what
interest the advocates of the postal principle. They seem
to recommend the obliteration or the confusion of the re-
lations between price and cost as a superior ideal. It is
important to be clear what exactly this ideal involves.

It involves, in the first place, as the whole argument
of this volume has gone to show, a less economical
employment of our productive resources; they would
be diverted to ends of less utility, and so produce less
real wealth. But this is not the worst. There is plenty
of waste and maladjustment in our economic system at
the present time. The desirable relation of price to
marginal cost is but imperfectly attained. The further
departures from this relation, which would follow from
any likely applications of the postal principle, might not
matter in themselves so very much. What is far more
serious is that the criteria of efficiency would become
blunted, and the clear aims of management would be
confused in fog. It is essential that every manager
should be on the alert to eliminate waste and to improve
efficiency, that he should be always trying to secure
the best results; but how can he do this if he has no
simple means of measuring what results are good and
what are bad? The measure which he has at present
is that of price, cost and the resultant profit, and it
would be fatal to take that away, unless an equally
simple and more accurate measure could be substituted
for it.

This is not a question, it should be observed, of
motive or incentive. Very likely we much exaggerate

THE REAL COSTS OF PRODUCTION 177

the importance of the profit motive. It may be true
that men would work, perhaps that they ah-eady work
in fact, as zealously for a fixed salary, as for personal
gain. But aim and motive are two somewhat different
things, and the aim of profit, is, and will remain, essential
to the efficient conduct of business. In a game the
players are not animated by the motive of scoring runs
or points, but they aim at them; and the zest disap-
pears very speedily from the game, if that aim ceases
to be of interest. Moreover, while a scoring system is
always a somewhat arbitrary thing, measuring im-
perfectly the true merits of the play, if it measures
them with the roughest accuracy, we prefer the issue
of our games to be decided so, rather than by the de-
cisions of an impartial judge, who can take into ac-
count the finest points of skill. So it is in the world
of business. The scoring-board of profits may be an
imperfect one; let us, by all means, where we can, al-
ter the rules of the game so as to make it better. But
let us not imagine that it displays a finer insight or a
superior intellect to speak as though the scoring-board
could be dispensed with, and the test of profit and loss
treated as irrelevant. Quantitative measurement is
essential to efficiency. Let us be careful to remember
all that this implies.

INDEX

Ability, 152
Accountancy, 58
Allocation of resources, 166
Ambiguities, 24
Australasia, 66

Bastiat, Frederic, 5

Beef and hides, 7

Borrowing and lending, system

of, 12
Business efficiency, 58
Business man as a purchaser, 47
Business risk, 104

Capital, 119; as representing a
period of waiting, 123; dis-
tribution, 131; distribution
and rate of interest, 137; ef-
fect on labor of an increased
supply, 77; not a stock of
consumable goods, 123; re-
action of price charges on, 31;
reflections upon, 11; supply,
130; supply as affected by
charges in interest rate, 132

Capital goods, 61

Capital market, 13

Capitalism, 17

Capitalist, 116

Chance, 105

Coal industry, cost of produc-
tion and price, 52; miners'
wages, 75

Coats, J. & P., 75, 155

Collective savmg, 129

Commodities, 7, 19; labor as a
commodity, 19

Competition, 140

Composite demand, 80

Composite supply, 80

Consumable goods, 123

Consumers' goods and pro-
ducers' goods, 49

Consumption, margin of, 37;
waiting for, 121

Control and risk-taking, 116

Controversy, 1, 6

Cooperation, 3; unorganized,
6,7

Costj general relation of price,
utility and cost, 65; price
relation to, 37, 39, 52; rent
as factor in real costs, 100;
ultimate, 82, 162; utility and,
165

Cotton and cotton-seed, 7;
contrast to wool and mutton,
71

Cotton industry, 154

Criteria of poUcy, 172

Currency inflation, 33

Cycles, 34, 125

Demand, ambiguity of expres-
sion increase in demand,"
24; derived, 82; elastic and
inelastic, 76; see also Com-
posite demand; Joint de-
mand; Supply and demand

Derived demand, 82

Derived utility, 49

Dia^ams, use of, 21

Diminishing utility, 40; money
and, 49

Directors, 135

Distribution of wealth, 131,
172; interest rate and, 137

Dividends, 135

Division of labor, 3

Economic laws, 140, 142; fun-
damental character, 17

178

INDEX

179

Economic theory, v, 143; fact

and, 1
Economic world, orderly na-

tiire, 1
Education, 150, 160
Efficiency, 58, 177
Elastic demand, 76
Employers' associations, 156
Enterprise, 104, 109
Entrepreneur, 113
"Equal pay for equal work,"

158
Expectation, 106

Fact and theory, 1
Farmers, 90
Fortunes, 116

Gambling, 106

Government, enterprises, 114;
failings, 139

Hides and beef, 7

Houses, 103

Housewife as purchaser, 41, 43,

44 47
Housing, 64, 129
Ideas and institutions, 141
Incompetents, 69

Increase in demand, ambiguity,
24

Index numbers, 172

Inelastic demand, 76

Inflation, 63

Institutions and ideas, 141

Insurance companies, 107, 111;
significance, 108

Interest, 119; necessity of, 129

Interest ra^e, 14; changes and
their effect on supply of
capital, 132; distribution and,
137; price of land and, 102

Intuition, 114

Joint demand, 66; importance
of the unimportant, 74; mar-
ginal utility under, 69; sum-
mary of considerations, 79

Joint jsroducts, 7; cost of pro-
duction, 40
Joint-stock company, 135
Joint supply, marginal cost
under, 66; summary of con-
siderations, 79

Keynes, J. M., vi

Labor, 139; apportionment
among occupations, 153; ap^
portionment among places,
147; apportionment among
social grades, 149; as a com-
modity, 19; cost, difficulty of
estimating, 163; division, 3;
effect of increased supply of
capital, 77; four grades, 149;
mobility, 148; product of,
119; reaction of price changes
on, 31; supply in general,
145
Laissez-faire, 11; retrospect on,

139
Land, characteristics, 83; dif-
ferential aspect, 87; margin
of transference, 94, 96; mar-
ginal, 88; price and rent, re-
lation, 102; question of real
costs, 100; scarcity aspect,
84; supply, 30; tenure, 92;
urban, 94; see also Rent
Landlords, 91, 92
Large scale business, 58
Laws, fundamental, 18, 29

Malthus, T. R., 146
Management, 104
Margin, danger of ignoring, 57
Margin of consiunption, 37
Margin of production, 52
Margin of transference, 94, 96
Marginal cost, aspects, 55; mis-
interpretation, 59; under
joint supply, 66
Marginal land, 88
Marginal purchaser 44

180

INDEX

Marginal utility, 42; price re-
lation to, 43; under joint de-
mand, 69

Market, 13

Marshall, Alfred, vi

Marx, Karl, 119

Mill, J. S., 86

Miners, 75

Monetary changes, disturb-
ances of, 33

Money, diminishing utility, 49

Monte Carlo, 106

Mutton. See Wool and Mutton

Natural ability, 152
Normal conditions, 36

Occupations, 150; apportion-
ment of labor among, 153
Order, economic, 5

Pasture versus tillage, 97

Pigou, A. C, vi

Policy, criteria, 172

Population, 85, 146

Postal charges, 175

Poverty, 131; national, 128,
129

Price, consequences of higher,
60; general relation with
utility and cost, 65; law of
tendency, 19; marginal util-
ity and, 43; post-war, 61; re-
action of changes in demand
and supply, 27; relation of
demand and supply to, 20;
utility and, 40

Producers' goods, 49

Production, power of, 125; real
costs, 162; waiting for, 120

Professions, 150

Profiteering, 75

Profits, 61, 177; elements, 104;
general analysis, 117; in
risky industries, 110, 115

Protective tariff, 169

Psychology and economics, 1

Purchasers, business man, 47;

housewife, 41, 43, 44, 47;

marginal, 44
Purchasing power, 33, 61, 172

Railway rates, 175

Railways, 64

Rate of mterest. See Interest
rate

Rent, 82, 83; complex char-
acter, 90; marginal land, 89;
necessity, 98; rate of interest
and, 102

Reserves, 136

Residuary profits, 110

Resources, allocation, 166

Risk, reward for, 104; under
large-scale organization. 111

Satisfaction, 50

Saving, 127, 174; individual,
127; involuntary, 134; psy-
chology, 133; social, 128

School teachers, 160

Service, 19

Serving cotton, 74

Shareholders, 135

Sinking-fund, 134

Situation, 88

Smith, Adam, v, 139

Social grades, labor movement
among, 149

SociaUsm, 9, 11, 14, 59, 134, 141

Speculation, 112-113

Steel smelters, 76

Subsidies, industrial, 169

Substitutes, 80

Supply, reactions of price
changes on, 30; see also Com-
posite supply; Joint supply

Supply and demand, changes
in, and their reaction on
price, 27; forces behind, 37;
general laws, 18, 29; relation
of price to, 20; wages and,
143

Supreme Allied Council, 169

INDEX

181

Teachers, 160
Theory, economic, v, 1
Thrift, 127

Tillage versus pasture, 97
Trade cycles, 34, 125
Trade depression, 33
Trade unions, 144; actions, 154;
wage level and, 156

Ultimate real costs, 82, 162
Unearned increment, 86
Unemployment, 168; trade

union policy and, 144
Utility, 37; cost and, 165; de-
rived, 49; general relation of
price, utilitjr and cost, 65;
law of diminishing utility,
40; law of diminishing utihty
as applied to money, 49;

marginal, 42; price relation
to, 38, 40; wealth and, 170

Wages, general wage level, 143;
trade unions and, 155, 156;
women's, 157

Wages Fund, 125

Waiting, essence of, 126; for
consumption, 121; for pro-
duction, 120

Waste, economic, 167, 168, 176

Wealth, distribution, 131, 137,
172; utility and, 170

"What should be" and "What
is," 141

Women's wages, 167

Wool and mutton, 7, 66; con-
trast to cotton and cotton-
seed, 71

Workers' control, 117

CAMBRIDGE ECONOMIC HANDBOOKS

General Editor: J. M. Keynes, Fellow of King's
College, Cambridge. Author of "Economic Con-
sequences of Peace," etc.

Assistant Editor: H. D. Henderson, Fellow of
Clare College, Cambridge.

SUPPLY AND DEMAND

By H. D. Henderson, M.A., Fellow of
Clare College, Cambridge; University Lec-
turer in Economics.

MONEY

By D. H. Robertson, M.A., Fellow and
Lecturer of Trinity College, Cambridge.

PUBLIC FINANCE

By M. E. Robinson, Lecturer in Economics
at Manchester University; Director of
Studies in Economics at Newnham College,
Cambridge.

THE DISTRIBUTION OF WEALTH

By G. F. Shove, M.A., King's College,
Cambridge.

THE CONTROL OF INDUSTRY

By D. H. Robertson, M.A., Fellow and
Lecturer of Trinity College, Cambridge.

POPULATION

By Harold Wright, M.A., Pembroke Col-
lege, Cambridge; Member of the Advisory
Committee on Fishery Research.

NEW YOEK : HARCOUET, BRACE AND COMPANY

LONDON: NISBET & CO., Ltd.

CAMBRIDGE: AT THE UNIVERSITY PRESS